Why You Need This Pet Products Company

In this episode of MarketFoolery, Chris Hill chats with Motley Fool analyst Jason Moser about the opening of American retail operations and also some of the latest earnings reports. They go through the results of a pet products company. Next, they talk about a discount retailer whose shares went up significantly. Finally, they talk about the changing experiences in restaurants and much more.

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This video was recorded on June 10, 2020.

Chris Hill: It's Wednesday, June 10^th. Welcome to MarketFoolery, I'm Chris Hill, joining me back by popular demand, Mr. Jason Moser. Thanks for being here.

Jason Moser: Hey! happy to be here; how's everything going?

Hill: Everything is going well. We're going to dig into some earnings, we've got some retail. I want to talk, sort of, more broadly about American retail operations starting to open up; and we'll get to those.

But let's start with the latest earnings out of Chewy (CHWY 1.92%), which is the online pet products company, reported a loss for the first quarter. Revenue looks good though. Active customers up 33% year-over-year. And I get that the stock is down 3%, 4% today, but the backdrop is, this is a stock that even with that drop, it's still up more than 60% year-to-date.

Moser: Yeah. I mean, when we look at all of the earnings reports that have been coming out here over the past earning season and guidance or lack of guidance reflecting the back-half of the year, because we just don't really know a lot of what is going on here as far as the pandemic is concerned. There has been a lot of uncertainty and a lot of companies pulling back on guidance. I mean, Chewy is, kind of, able to [laughs] really double-down on that; which is pretty interesting to see.

They're able to really take the guidance that they're offering and even go one step further. And what I mean by that is, last quarter, when they reported earnings for the fourth quarter of their year last year, they didn't offer guidance for this year at that time, they did offer quarterly guidance, they didn't offer full-year guidance. This quarter, they actually did go in there and they gave us full-year guidance, which I think is really interesting and I think it's a testament to the merits of this business.

I mean, we talk about essential businesses, and Chewy qualifies, certainly because ultimately this is a business that is helping us keep our pets alive. And for a lot of people, myself included, our pets are part of the family.

You know I love the pet market, it's a massive market opportunity. In their S-1, they listed that market opportunity effort and that they're pursuing around $70 billion. And I think this goes back to something we talked about late last week, in that Amazon (AMZN -1.65%), for a long time, has done a great job in staking their claim in this e-commerce world, but what the pandemic did, because things happened so quickly, the pandemic really marginalized their services a bit. And Amazon has not quite been able to live up to those promises that they've been living up to over the past several years, and next-day delivery, two-delivery and what not. There are a lot of things you can order right now that you can't get in the same frame of time and it's giving companies like Chewy an opportunity to jump in there and prove their worth, even more so.

And we certainly saw that with first quarter sales up 46% from a year ago. And when they talked about that guidance for the full-year, I mean, they're talking about total revenue in that $6.5 billion range. So, this is a business that is growing very quickly, and frankly, I do understand why.

Hill: It's a great point about Amazon. And I think that there were some people in the financial media, you go back a couple of months, people writing columns about like, you know, that Amazon has broken the trust of their customers, you know. And I just, sort of, look at it and think more in the terms that you just laid out that it's like, well, yeah it would've been great if everything, if all the fulfillment issues [laughs] had been taken care of and that sort of thing. I don't look at it so much as, well, I no longer trust Amazon; I look at it as, Amazon just opened the door for all these other retailers to establish themselves and establish a relationship, a trusted relationship.

And in the same way that we talk about streaming entertainment, like, look, you're going to have more than one streaming service; it's the same sort of thing. It's like, it's not that hard to manage [laughs] multiple online retail accounts, particularly if you have pets. And it's like, yeah, we'll use Amazon for some stuff, maybe we'll use Instacart for grocery, you know; and it's like, yeah, and for our pets, we're going to go with Chewy.

Moser: Yeah. I think you're right. It was less about Amazon maybe breaking the trust and really more about just that idea you mentioned. I mean, this is a big opportunity where we can see more than one winner. And you know, the thing I like about Chewy is they really are pursuing a specific market, they're focusing on doing one thing and doing it really well.

And just to go into some of those other numbers that substantiate that. I mean, they added 1.6 million net active customers in the first quarter, and that was more than double their average quarterly pace in 2019. They ended the quarter with 15 million active customers, and that was up 3.7 million compared to the first quarter of 2019. The fastest acceleration of new customer acquisition in the company's history.

And then they have this Autoship function, which essentially just takes the thinking out of it. Amazon has the same sort of thing, Subscribe & Save. Those Autoship customer sales exceeded $1 billion for the first time in a single quarter. And so, then when you start looking at the fact that they now are keeping the customers that they're bringing in, I mean, there's kind of a Wayfair dynamic here to this business model. No, they're not really making any money right now, but that's OK, because you can at least see the path to how they get there. And it's ultimately bringing customers in and then keeping them.

And if you're bringing customers in and able to get them the products they need in a timely fashion and at a good value, they're going to tend to stick around. And with Chewy, it's not just food, they're also talking about the medical supplies, whether it's heartworm medicine or flea and tick medicine, whatever that might be too, they have that dynamic to the business as well.

And because of all of this, they're building out their capability, they just launched a new fulfillment center in Charlotte in April. You're starting to see that they're able to pull back a little bit on these acquisition costs, and that's starting to flow more down to the bottom-line. Now, they're not to that magical profitability number yet, but they are getting a lot closer. And this was a quarter that, I think, really demonstrated the potential of what this business has.

And I'll just wrap it up by saying this, you know, for the longest time we've used Amazon to get our dog food. Like, we have two dogs now and we get that dog food sent to us, and it has always worked out well. I mean, I can tell you for sure, I've noticed over the past several months, it has not been as quick as it usually is. I am going to give Chewy a shot, I'm going to get Chewy a try here.

And I have no problem doing it because I feel like maybe this line of work is more important to them than maybe it is to Amazon. Amazon does a whole lot of stuff. Chewy is focused, so they really want to nail it and get it right. Yeah, I'm going to give it a shot and see what it's like, because if it is good, then I suspect I'll be one of those autoship customers in quick fashion.

Hill: Shares of Five Below up more than 10% today after the discount retailer issued a loss for the first quarter. Not surprising that they came out with a loss, like so many retailers, all these stores closed. They did say though that most of the Five Below locations are back open at this point.

Moser: Yeah, I think they said that they've got 90% of the stores back open now. And they have 920 stores today in 30 states. And, I mean, to give you an idea of what they see as potential out there, I mean, they see a market out there with 2,500 stores. Now, that would be a mix of opening new Five Below's along with making some acquisitions along the way and bringing some of those other smaller concepts into their family. But regardless, based on their thinking there's still a lot of story to tell here. Now, whether that is the case, I'm not entirely sure. I mean, I have been at Five Below a couple of times and I get the value proposition, I get what they're doing. It does feel like that's a story you actually have to set foot in.

You know, they noted in the call that they were able to roll out this curbside pickup, which I mean, that's more based on ordering online and then picking up at the store. And e-commerce is a factor to this business. They saw e-commerce sales grow over 4X versus last year's same quarter.

Now, they also noted that that growth has moderated, and ultimately, e-commerce is really low-single-digit range percentage of total sales, but it is a part of the business that matters, but with that said, they focused, as many companies have focused now, on getting in cash conservation mode. They increased the line of credit from $50 million to $225 million. They are pulling back on store openings right now. They are opening 100 to 120 stores this year, as opposed to the 180 target that they had earlier, before the pandemic started.

So, I mean, there's not really anything surprising in the results here. You would assume that sales would be down considerably because they had to close for a while; it does seem like they're able to get back up and running here. And it does sound like there's a big market opportunity that they're pursuing. So, I think, I would put myself as, sort of, cautiously optimistic at this point regarding this company.

Hill: But to go back to your point about the importance of getting people in the stores, it does seem like one of those retailers where impulse buys can help raise that average ticket. And I just have a hard time believing there are going to be as many impulse buys online as there will be if you're actually in a Five Below location.

Moser: Yeah. I mean, there is a nature to this business that is, sort of, impromptu. And that's a sword that can cut both ways. I'll be interested to see, longer-term, if they're able to make that e-commerce side of the business become a more meaningful driver, because, you know, a good example that was made in the call, and I think this is important for folks who ever invest in restaurants or retail, you know, we always talk about traffic and same-store sales. And it goes to the fixed costs that are involved with keeping these stores open.

And with Five Below, 25% of their cost of goods sold are fixed, in other words, you know, that's rent, that's keeping the lights on, the bills paid, insurance and whatnot. So, whenever they see traffic fall and they see sales fall, that 25% cost of goods sold becomes more of a drag on the financial performance. They don't see the same profitability numbers. And it brought gross profit down about $100 million for the quarter for them.

So, they always do have to consider the fact that they have fairly high fixed costs in that regard. One way to really offset that, beyond just generating traffic, is to develop a more robust e-commerce business. and given where it is today at low single-digits, I mean, there's clearly the opportunity to make it a bigger part of the business, and I think that's going to be a key to their success.

Hill: Real quick before I let you go, I want to get your thoughts on just sort of what you're watching over the next month or so. You go back maybe six weeks and Kevin Johnson, CEO at Starbucks (SBUX -1.02%), was talking about how his goal was to have all U.S. locations open by early June. It's June 10^th, Starbucks actually came out with some updated guidance. They're at about 95% of locations in the U.S. that are open to one degree or another, but they're going to take a $3 billion hit in the third quarter. They do expect that average weekly cash flow to be positive by the end of Q3; so, we'll see how all of that shakes out.

But as we start to move into Summer what are the things that you're going to be watching to get clues of how the U.S. economy is recovering?

Moser: Yeah, as it pertains to Starbucks, I mean, this is a really interesting one, because it's starting to become more apparent the investments they made in that mobile ordering, that mobile offering that they have. It is good, it's certainly something that has helped them manage their way through a difficult time. And just like with Five Below, I mean, Starbucks obviously maintains a very high fixed cost structure because of all those stores.

And, you know, for the longest time, those stores were built out under the notion that, you know, they were building this "third place" experience, right? That was something that we always heard them talk about early on. Creating this ambiance of a place where you can go. Not home, not work, but kind of another place where you can go to maybe feel like you're at home, and yet get some work done and drink some coffee or eat some food during the process.

And I do wonder, longer-term, if we're going to see -- because, you know, we always talk about Starbucks not really having a lot of the way drive-thrus, just Starbucks doesn't really have in a lot of way drive-thrus. And now, drive-thrus seem to be like a really big asset for restaurants and the like to have. I wonder how they're going to view that third-place mentality in the coming years. Because I feel like, the longer we go with -- you know, like, Northern Virginia, we're going to enter phase two on Friday and phase two ultimately means that restaurants can operate at 50% capacity.

Now, I mean, ideally, we get back to normal at some point where restaurants can operate at 100% capacity and things move forward, but it does make me wonder, with Starbucks going forward, how are they going to be viewing that third-place mentality? Do they ultimately go back to really focusing on that or is this sort of the catalyst that sort of takes them away maybe from that third-place mentality and more on just the customer-centric omnichannel, kind of idea, be wherever your customers want you to be?

And if customers are ordering mobile, swinging by and picking it up or if customers were asking for a drive-thru, like, maybe customers don't really want that place anymore. And if that's the case, that's fine, but that certainly is going to impact not only their store opening strategy but also how they're designing stores and the cost that goes into maintaining those stores.

Because, you know, we've seen all sorts of companies out there talking about looking at some concessions on rent through their landlords, because of this difficult time, because business has been stifled. And Starbucks was no exception there. Starbucks went to their landlords asking for some rent concessions. Now, the flipside of that, people might say, how in the world could Starbucks be in such a financial position where they're demanding rent concessions? I mean, I'm sure they're not, but I can understand why they're trying. And so, maybe that is something that going forward they think, you know what, we're not going to be so focused on this "third place," we're going to be more focused on mobility and omnichannel and being where our customers want us to be, and that certainly could adjust the cost structure of this business longer term.

And who knows, maybe it works out, it gives them a chance to open even more locations in more places at lower costs to drive more traffic and ultimately become more profitable.

Hill: It's interesting, because we have talked a lot about, well, what is the future of office space and commercial real estate? And thinking about downtown Manhattan, and you know, is that going to become a ghost town now? But you raised an interesting point about whether it's Starbucks or any large national, whether it's fast casual, any kind of restaurant concept, what is the future of that look like? Are they going to be reimagining them?

And I think back to Ron Shaich at Panera Bread, when he came out years ago with his comment about, you know, coming to Panera Bread is like entering a mosh pit. And he laid out this two-year plan, said we're going to improve the experience inside, and that worked for Panera Bread. And obviously, they didn't know the pandemic was coming, but they inadvertently ended up building this really great business that was optimized for delivery and pickup.

And I think you raised a great point about Starbucks, which, in the heyday of Howard Schultz running the company in the 90s, it really was that "third place" concept. And it won't surprise me if Kevin Johnson comes out in the next 12 months with some kind of similar comment about, like, the future locations, we're going to have more drive-thrus and they're going to be more optimized for pickup.

Moser: Yeah, and they're easier to staff, you know, they eliminate a lot of the concerns that we're seeing right now. Social distancing becomes less and less of an issue, sanitary conditions are clearly held to a better standard. There are a lot of advantages that come from it. But, yeah, ultimately, at the end of the day, it's a matter of what customers want. And I just can't help but feel like maybe the customer of the future maybe doesn't care as much about that "third place" as the customer of the mid-1990s.

Hill: Jason Moser, thanks for being here.

Moser: Thank you.

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd, I'm Chris Hill, thanks for listening, we'll see you tomorrow.