In this episode of Industry Focus: Consumer Goods, Emily Flippen and Motley Fool contributor Asit Sharma discuss the growing pet industry and the opportunities it presents for investors. They talk about how various major players in the industry are finding new ways to reach their customers and expand their businesses, and what their futures hold. They also discuss what one of the biggest players' advantages are, whether a new IPO could disrupt those advantages, and much more.

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This video was recorded on Dec. 14, 2020.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, Dec. 22, and I'm your host Emily Flippen. Today, I am again joined by The Fool's Asit Sharma to take a walk on the wild side with me as we wrap up 2020 and discuss this insane pet craze that has really taken the world by storm.

Asit, as always, thank you for joining.

Asit Sharma: Emily, thanks for having me; and I love the idea of this being a "walk on the wild side." For me, when you look at the pet industry within this sleepier consumer goods [laughs] industry, it is very much so. In fact, the melody from The Velvet Underground's famous song with the same title is playing in my head as you speak.

Flippen: [laughs] Well, it's always fun to, kind of, focus on what was traditionally known as a slow-growth industry, on these little pockets, that seem to have really growthier prospects, especially because I have to compete with Dylan's Friday Tech show. Do you know how hard that is? You know, you've got to throw some exciting growth stories in this consumer goods industry here. [laughs]

Sharma: We need to keep Dylan Lewis on his toes. He doesn't have the lock on high-growth stories, we got them here in CG too. [laughs]

Flippen: [laughs] And we'll talk about definitely one, maybe two, we'll discuss whether or not we buy into it on today's show. But before we do so, I should clarify that we're actually pre-recording today's episode on Dec. 14, since I will be out on Dec. 22 when this is airing. I'm keeping my fingers crossed that nothing crazy in the high-growth pet industry [laughs] happens between now and Dec. 22. I'm hopeful that will be the case, but in case it does, apologies in advance.

And we'll get to it all, but before we start, I do want to talk about one of my favorite pet investments that recently reported earnings. Probably every listener is banging their head against the wall right now because they want me to stop talking about this company, but I can't -- I love it, I'm a shareholder, I'm a customer -- and that is Chewy (NYSE:CHWY).

Chewy reported earnings on Dec. 8, and in my opinion from what the company and management said, it was clear to me that growth in this e-commerce giant really hasn't slowed down.

Sharma: Yes, Chewy continues to fire on all cylinders, Emily. And I think listeners aren't angry with you. If they have been listening to you, [laughs] they've made a lot of money purchasing Chewy's shares. The stock continues to impress. I'll give a few statistics from the earnings and then we can move on, talk about some other exciting things going on at Chewy. Net sales increased 45% year-over-year. And autoship, which is sort of their recurring, just-leave-it-on-automatic platform for those who order online from Chewy, representing almost 70% of net sales. So, we see that automatic, programmatic buying, leave it and forget it, increasing as a percentage of total sales, which is a really good sign. They have just under 18 million active customers as of the end of this last quarter, and that's increased 40% in 2020. Sales per active customer came in at $363; that is a really big number to me, Emily. [laughs] I am not a person who orders anything online for pets, because right now we don't have any in my house, but that to me, it's almost a stunning number as an average number, that's a 3% year-over-year increase.

We should point out that Chewy has been trying to increase its private-label sales. In fact, in earlier quarters this year during the pandemic, management was really working hard on their interface. They've invested a lot of technology to be able to shift viewer's attention based on what inventory is in stock, and that really helped them during the earlier part of the pandemic and it continues to help Chewy. One of the things that management was talking up earlier this year was their private-label sales and how they were able to substitute some private-label sales, this was in the spring, when they were running into supply chain problems due to the pandemic. That was a big boost, and those sales were up 16% year-over-year.

Lastly, I wanted to call out two more things. The company's gross margin increased by about 180 basis points. I know Chewy has a really poor gross profit margin, [laughs] Emily, and this is one of the knocks that I've had on the stock in previous quarters. But you know, they keep inching that up quarter after quarter. Just in the last year, I'm looking at a chart as we speak (which you can't see, viewers), but Chewy has increased its gross profit margin by about 500 basis points in a year's time, and that's significant. They are building out their distribution centers, which, as they scale, helps them with that gross margin. So, I saw a lot of positive stuff in this quarter, and I know you've got some stuff as well that you wanted to call out.

Flippen: [laughs] It was all positive things for me. To your point on gross margin, that's a fair criticism, it's the reason why private-label sales are so important for Chewy. It's because those are higher-margin products that they sell through, but ultimately, Chewy will never be a SaaS company, right, they report on a gross basis.

But one of the things that I really did want to point out, and it makes me really excited as a shareholder, is the pharmacy business. This is a business that Chewy recently got into, and it's not without controversy. A lot of vets out there are a little bit afraid about the disruption that e-commerce pet pharmacies could have to their business model, but I think Chewy is going about it in a really exciting new way.

So, to start, Chewy Pharmacy, which is just the sale of pet meds, is expected to generate over $350 million in net sales this year, which will be 5% of revenue, and they expect it to be accretive to gross margins this year. Outstanding for a new product line. They're also getting into a couple of different ancillary pharmacy areas. One is what they're calling Chewy Compounding, and this is actually the process of customizing pet medication. So, if your dog, for instance, really doesn't like pills, they prefer to have something maybe in their water or to have something in a different form, they're working with pet drug producers to change the forms of these medications to be better suited and better tailored to your specific pet. That's still in its very early stages, but it's the thing that I get excited about.

I know feeding medication to pets is probably the least favorite thing that pet parents have to deal with, but there's also a thing that -- I'm stealing this from JMo, Jason Moser, he called it a "Teladog" and I loved that. [laughs] So, Chewy is getting into Chewy telehealth, like Teladoc for your dog. It's where you can download the Chewy app, connect with an expert to talk about any health concerns you have about your pet. And this doesn't expose the company to as much liability as you may assume, because they're not trying to diagnose, treat, cure, prescribe anything for your pet over the phone. They're actually trying to get an initial diagnosis that they can then refer you to a local vet in their network to help treat your pet's illness. So, it actually ends up being a good thing, in my opinion, for local vets. In particular, all of this has been made somewhat possible because of their ownership through PetSmart, which has a relationship with the Banfield Pet Hospital. So, there's a big network that's happening here with Chewy.

Everything you just mentioned, plus the pharmacy segment, makes me really excited to be a shareholder of Chewy today.

Sharma: Yeah, and I think this is one of the things that I missed early on with Chewy. And I've become a fan, if I didn't make that clear before, I think maybe last quarter. And you're one of the reasons, Emily, because I know you've been talking it up [laughs] on Industry Focus, and also, in our Live service for members who get to see us interact on-screen and talk [laughs] about stocks you like.

I think you really changed my mind in terms of looking at the management structure. I think the management team is really strategic. One of the things that they've keyed in on is this pet humanization trend. So, it seems to me that Chewy is asking the questions that relate to this trend. How can we tap into this? And it's not all mercenary, [laughs] I don't think they're doing this just to increase sales to the utmost degree, I think they really care about the product, and that's sort of obvious in the customer touches, but I think they are very cognizant that this is how you build margin in the industry, which is to anticipate how pet owners will respond to innovations that are humanizing their pets.

So, be it the pharmacy, be it Chewy telehealth/Teladog. Chewy Compounding, which I think maybe out of these is the one that I am most excited about, because you know your pet better than anyone. So, you know what your pet likes and doesn't like. The idea of compounding goes back and reminds me of, boy! You know, the 19th century. This was a really big deal two centuries ago, in that, when you needed something you'd go to your local pharmacists and they weren't called pharmacist then but the name is escaping me, apothecary maybe, and you would have stuff mixed together, you would have it compounded. That's a really awesome way to engage loyalty, to build lifetime customer value and all the good stuff that we look for to make sure that a company like this, which is essentially an e-commerce layer on a growing distribution arm, can continue to extract more and more sales out of its customers. You know, I mentioned that really amazing spend per customer. So, yeah, these are all great moves from the company.

Flippen: We're also getting news out about a new pet-related IPO. It doesn't have me as excited as Chewy's 2018 IPO, but it may interest some investors, and that's actually Petco. It's filed its S-1 to go public next year. The ticker will be, hopefully, Nasdaq: WOOF. [laughs] So, extra points, I think, for scoring what, in my opinion, is a great ticker. But when I read through this S-1 -- I'm not sure about yourself, Asit, I was a little less than enthused to start, and I'll hand this over to you in a second, but I have to call this out, to start, the S-1 started with a letter from Petco's CEO, Ron Coughlin.

And Ron Coughlin says -- and this is in bold, all-caps, I think one word is even underlined: "Today, Petco is the only complete health and wellness company for pets." And I don't know about you, Asit, but to me, [laughs] it's never a good thing when a company starts off their S-1 by lying to my face.

Sharma: No, it's not. And the first thing that comes to mind is, boy! What kind of marketing gloss is going to be over the rest of this whole prospectus? [laughs] If they have to start out this way, I'm guessing the numbers aren't going to look great -- and we'll get to that. But you know, we just talked about a company that you could argue is sort of a complete health and wellness [laughs] company for pets. It's got the pharmacy portion, it's working in telehealth, it's working with veterinarians, it's got the food, the toy element, what else do you need when you are a company like Chewy to make pet owners and pets happy? So, that was a stumbling block for me.

And something else actually, right from the start of this S-1. So, an S-1 is the registration statement when a company files to go public. It's got all the information, financial and the narrative, information about management. We use that term interchangeably with "prospectus," so if you hear me say S-1 or prospectus, I'm talking about the same long document. [laughs]

At the very beginning of this document, I want to read this quote: "Over the last three years, we have transformed the business from a successful traditional retailer to a disruptive, fully integrated, digital-focused provider of pet health and wellness offerings." That word "disruptive" sort of stuck in my mind as well, because if you know Petco, it is more of a traditional retail-based operation, and they've only recently thrown an e-commerce layer over that whole thing, Emily. So, I'm not sure how getting into the omnichannel business, which is what the rest of the consumer goods world is doing, whether you're in the pet business or not, how disruptive that is? [laughs] So, that raised my antenna too.

Flippen: [laughs] It's funny you say that, because I agree, it seems like e-commerce is an afterthought here. Admittedly, this is a new management team, right? Ron Coughlin came in, I believe, a couple of years ago, attempting to turnaround the business around 2018. And there has been some success in increasing what was negative same-store sales growth up to pretty consistently positive. But if you look over the course of the second half of 2018 into 2019, the company, Petco, had consistent same-store sales growth of 2% to 4%. So, it wasn't terrible. Obviously, the pandemic has significantly helped that same-store sales growth.

But withholding that, the thing that I did find disruptive about Petco is something that I'm aware of, just from a consumer perspective, and that's Unleashed. I'm not sure if you've seen these Unleashed stores, there are only a collection of them, there's 59 across the United States. They're smaller format pet stores, a little bit more premium. I didn't even know they were associated with Petco until reading this S-1. I thought that was disruptive, because it struck me as a completely new business model, a change of branding from these big format, kind of, dank-y pet stores to something sleek, convenient, in cities. But Petco only mentioned Unleashed once in their entire S-1, which to me says, management isn't even focused on expanding that brand. So, the one thing I liked here doesn't even seem to be on management's radar. [laughs]

Sharma: [laughs] Yeah. Curious because you would think, with a small footprint store that is innovative, that would be something they'd really be trying to promote in the S-1. But it reminds me of Dollar General, which has a subset of stores that are similarly innovative and have a smaller footprint, they look very modern, [laughs] they don't look like the type of Dollar General store you usually see, it's called DG, and they often have them in higher rent areas. But you know, relative to the entire store base, that's a really small footprint for that concept.

And I think you mentioned 59 stores versus the entire Petco footprint; right now, it's not very big or is not something that may move the needle, but yeah, OK, we'll give it points for being disruptive there for sure. And maybe, as time goes on, if that proves it out, management will start to put more attention, more resources to that, if they see that that's where the sales and sales growth is moving toward.

Flippen: To me, reading through this S-1... very rarely do I tell investors it's probably not worth your time to read an S-1. I think reading S-1s, in general, is a great way to learn about companies. This is one that I have to say I think I would pass on. And I don't say that lightly. This, to me, struck me as a classic money-grab scenario. They're owned by a private equity firm that has heavily levered up this company, so they're heavily indebted. They're planning on using some of the proceeds from the IPO to pay back their 9% debt, which in these markets right now is extremely expensive debt for a company that is consistently profitable, consistently generating cash flows, especially if you're a believer in its long-term growth.

So, to me, I don't want to be the person that is financing Petco, especially when there's Chewy right in front of me, right? I mean, and that's co-owned by PetSmart. To me, there's a clear innovator in this space, and then there's this laggard that is just doing its best to run on the treadmill and catch up. So, it's not really interesting to me. Asit, what about yourself?

Sharma: Yeah, I tried to make the numbers work [laughs] looking forward. So, just some notes that you had pointed out when we were prepping for this podcast. So, $4.4 billion in net sales in the last fiscal year. They had operating income of only $110 million and they had a $100 million net loss. Now, that net loss was propelled by this huge interest expense, hence trying to come to market [laughs] to pay down some of this debt that's at 9% that you talked about.

But you know, when I started digging into the numbers, they have this sort of structural equation which is, it's hard [laughs] and it's a little confusing. They've got really nice gross margins for a retailer. So, you know, we talked earlier in this episode about Chewy, which has gross margins now of, I think, about 25%. This company has gross margins of 43%, [which] looks nice, but they've got a higher selling, general and administrative [SG&A] percentage relative to sales than most other retailers I see in any category; that number is up to 40%. [laughs] So, you're only left after that, with what, if you add those two numbers together, 17% to work with. [laughs] You have to really scale sales to make that work. And if you can't grow sales quickly enough then you're forever going to be with these slim profits that can get totally knocked out by the interest expense on your debt or maybe because you have the slow model you're having impairments which in previous years -- the S-1 show, they've taken some big charges against their brand. [laughs]

So, I feel like, yes, I agree with you, this is best avoided. If you still are a big fan, let's say it's your favorite place to shop, at least let this one season for a few quarters, maybe there will be some innovation coming up and the revenue will take a different direction and they'll show more profitability. It's doubtful right now just looking at what they've brought in terms of an offering document, but you know, anything can happen. [laughs]

So, if you really love this, I say maybe wait a bit before you just jump in.

Flippen: That's a good analysis. We could be wrong about Petco. You know, we talked last week about Stitch Fix. The same way we mentioned at the end of last week's show that we could easily be wrong about Stitch Fix, we could come back in a year and Stitch Fix had an amazing year, they've grown customers and the same could be true for Petco. Maybe Petco is going to reform the brand.

But to your point, look, they've taken, what, almost $15 billion [laughs] in impairment losses against the Petco brand and its acquisitions up to this point. I feel like we have a much better chance about being wrong about Stitch Fix than we do about being wrong about Petco here. Either way, when I look at Petco in comparison to Chewy, oh, man! I'm going to sound like a broken record, but for me, it's Chewy hands down, even with the gross margins.

Sharma: Yeah, absolutely. The thing about Chewy's margins is simply, if management is correct, those are going to improve as they build out distribution. And at some point, they will be on a continuous basis just cash flow positive, positive by generally accepted accounting principles, [GAAP] so all that sort of long-term path which you can see in real-time being built, and it's a path of least resistance, because they've got such a strong sales component, and their products are so popular with consumers. They are growing that top line by [laughs] strong double digits. Here you've got sort of a wall.

The wall is how Petco's financials are set up. They've got a lot of overhead, they're in a slow-growth retail model, they're sort of stumbling into this omnichannel e-commerce model. It's going to take a while, but they're going to have to, sort of, climb over a wall. [laughs] So, it's the path of least resistance in Chewy versus climbing over this wall that they're butting their heads against with Petco.

And again, you know, I'm with you there, there's a reason, Emily, why you have been cheerleading the stock, because you saw the potential. And I think the stock price has sort of proven that this year. [laughs] So, again, you are entitled to that head-on-head comparison; I would take Chewy as well.

Flippen: [laughs] Well, I appreciate the ability to give me a platform from which to constantly repeat my enthusiasm for Chewy as a company; I promise I own other companies, investors and listeners. You will definitely get the opportunity in future episodes to hopefully hear me talk about them, [laughs] but until then, Asit, as always, thank you so much for joining.

Sharma: Yeah, I appreciate this opportunity for the walk on the wild side; [laughs] it was fun.

Flippen: And listeners, that does it for this episode of Industry Focus. If you have any questions or you just want to reach out to say "Hi!" you can always shoot us an email at IndustryFocus@Fool.com.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for his work behind the screen today, for Asit Sharma, I'm Emily Flippen, thanks for listening, and Fool on!