Investors weren't thrilled with the latest earnings report from Chewy (CHWY -0.81%). The stock dove immediately following the fourth-quarter announcement, covering the selling period through late January as sales and earnings missed expectations.

Chewy's executive team said the shortfall was driven by demand and supply-chain pressures for pet supplies that should ease over the next few quarters. But fiscal 2022 will still reflect progress toward management's ambitious sales and profitability goals.

Let's take a closer look.

A dog holding its bowl in its mouth.

Image source: Getty Images.

Missing expectations

The main worry on Wall Street was that Chewy came in below the 19% sales increase that most investors had expected. In a conference call with analysts, CFO Mario Marte explained that the miss was mainly due to weaker customer retention in Q4. That idea spooked Wall Street, since it might reflect market share losses or a declining competitive advantage .

That's not what management thinks is happening, though. Executives say the increased churn was due to a few unusual aspects about the group of customers who signed up for Chewy deliveries in late 2020 when the COVID-19 pandemic was at a peak. Demand back then was tilted more toward such items as leashes and feeding bowls rather than pet food, which is purchased repeatedly throughout a pet's life.

Overall engagement looks strong with a record 71% of customers signing up for subscription-based orders, suggesting the weak finish to the year was an anomaly. "The year one retention of our Q4 2020 [customers] was below what we typically observe," CEO Sumit Singh said.

Handling costs

Chewy also stumbled on the earnings front as soaring costs hurt profitability. Gross profit margin fell to 25.4% of sales from 27.1% of sales a year ago. Adjusted earnings fell to a loss of $28 million compared to a gain of over $50 million in late 2020.

The e-commerce giant saw profit pressure from labor shortages, higher transportation costs, and supply-chain disruptions. Executives aren't phased by the downturn, though. "We believe most of these challenges are not permanent in nature," Singh said. Yet the challenges still took a big bite out of 2021 earnings and threaten to pressure margins through early 2022.

The case for a rebound

The good news is that Chewy has everything it needs to reverse that trend. Management is planning faster price hikes and more cost cuts, in fact, so that the gross profit margin starts moving toward as high as 28% of sales.

It might take a quarter or two before its clear that the Q4 drop in customer engagement was a one-time event. But given the high renewal and order rates overall, it is likely that the slump was simply a consequence of pandemic-related volatility.

As a result, investors who've been watching Chewy stock from the sidelines might consider buying it after the recent sell-off. The e-commerce part of the pet product industry should grow at a high rate over the next few years. Chewy's dominant position should help it capture more than its fair share of those gains even as profitability bounces back from the recent decline. That's a formula for accelerating earnings growth and solid returns for investors.