Head over to Valley View Business Park in Archbald, Pennsylvania, and you'll see a construction project underway. Pet product e-commerce company Chewy (NYSE:CHWY) is working on a fulfillment center (the company's 11th), which doesn't sound remarkable. But it will be Chewy's first automated fulfillment center, and that's something investors should pay attention to.

The company grew revenue by 40% in 2019, an impressive feat. But it also recorded a net loss of $252 million, making a path to profitability imperative. That's what this new automated fulfillment center is supposed to provide.

Coins are placed in jars with plants growing out of them.

Chewy is investing to make its business profitable. Image source: Getty Images.

New fulfillment centers

Chewy is a growth stock. It was already growing at a rapid pace: Full-year net sales more than quintupled from 2016 through 2019. And the COVID-19 pandemic has further boosted the adoption of e-commerce platforms like Chewy. The company noted its sales sped up in February and were still unusually high as of the beginning of April. 

For growing e-commerce operations like Chewy, it's crucial to have a network of strategically placed fulfillment centers. Customers expect shipped purchases to arrive quickly, and companies can speed up the process by storing products as close to the end consumer as possible. Just last year, Chewy only had seven fulfillment centers. Now its 10th should already be open in Salisbury, North Carolina, speeding up shipments for customers in the Southeast U.S.

But it's the upcoming 11th fulfillment center that will be automated. In its fourth-quarter earnings call, management gave some statistics for this location. It said throughput (how much merchandise it can ship) will increase 25% compared with a fulfillment center of comparable size and productivity (work accomplished per employee) will go up 50%.

Holding physical real estate and paying workers are largely fixed costs for Chewy. But automation will allow it to gain operating leverage in these areas. This will result in fulfillment cost per unit (how much it costs to ship each item) going down 30%.

CEO Sumit Singh called the Archbald center a "state-of-the-art facility" that will "raise the bar on future upgrades to our fulfillment network."

A man sticks his finger through an empty wallet.

Chewy is closer to positive territory than it looks. Image source: Getty Images.

Future upgrades needed

If Chewy's new fulfillment center, slated to open late 2020, delivers on these projections, it will nudge the company toward profitability, a crucial issue for investors still on the sidelines. 

If you break down Chewy's 2019 net loss of $252 million, more than half was due to stock-based compensation. In fact, if stock-based compensation in 2019 had been the same as in 2018 ($14 million), the company would have been profitable on an EBITDA basis.

Stock-based compensation is a noncash item and is typical with young companies like Chewy. Still, it will remain a headwind for profitability on paper. Consider that, according to the company's annual report, there are around 21 million remaining unvested and outstanding restricted stock units (used for stock-based compensation) with an average value of $36.20. 

Stock-based compensation aside, when looking at cash flows, Chewy is closer to positive territory than you'd think. It generated $47 million in cash from operations in 2019. And it generated $60 million in free cash flow in the fourth quarter alone, finishing the year with negative free cash flow of just $2 million. Reducing its fulfillment costs by 30% could easily push it over the top.

But the 30% improvement is only for one of Chewy's 11 fulfillment centers. So on its own, it might not be enough. But Singh mentioned future upgrades to the fulfillment network. Perhaps from here, its existing centers will be retrofitted with automation upgrades, yielding a 30% improvement for the entire company. That would move the needle.

A working man uses a level, with a dog sitting next to him.

Those invested in Chewy eagerly await the completion of its new fulfillment center. Image source: Getty Images.

For now

It all starts with the Archbald fulfillment center, which is worth monitoring after it opens. It might not show immediate improvements to Chewy's results, but sometime in 2021, I would expect an update from the company about this location. If it's as good as hoped, and it serves as a blueprint for the rest of the network, that would contribute to a long-term bullish Chewy thesis.

By contrast, if it's not what it's cracked up to be, that would be a problem. Chewy does currently have a profitability problem, and this is an important way the company is addressing it. Failure in this early effort would give me pause about the business model's long-term viability.