Pet e-commerce company Chewy (CHWY 2.21%) reported financial results for the third quarter of 2022 on Dec. 8 and the market loved it. The stock immediately rallied about 6% and has now doubled from its 52-week low.
Overall, Chewy stock is still down about 25% in 2022 -- a disappointing year. Will it fair better in 2023? The company certainly has some large opportunities, but there are also some challenges it will need to overcome if it's going to beat the market from here.
What's going right for Chewy
Chewy went public in June 2019 and it looked like many newly public companies: high growth but unprofitable. The company grew net sales by 40%, 47%, and 24% in 2019, 2020, and 2021, respectively. However, in those years it also registered steep net losses of $252 million, $93 million, and $74 million.
The script has completely flipped for Chewy in 2022. Through the first three quarters of 2022, Chewy's net sales are only up 14% from the comparable period of 2021. However, it actually has year-to-date net income of $43 million.
What happened? One of the most notable improvements for Chewy has been its gross profit margin expansion, as seen in the chart below.
Chewy owns and manages its own distribution network so that it can offer fast shipping to effectively compete with the likes of Amazon. The company has 13 fulfillment centers, with two more scheduled for opening within the next 15 months.
What's interesting is three fulfillment centers are already automated -- they come equipped with gadgets like high-speed sorters, robots, and conveyer belts. Importantly, way back in the fourth quarter of 2019, Chewy management said that by automating its fulfillment centers it could save 30% per item fulfilled. That's indeed played out, bringing down Chewy's expenses, improving its gross margin, and helping it turn a profit.
Therefore, Chewy's progress wasn't an accident. It was the result of years of intentionality. The next two fulfillment centers for Chewy will also be automated, which will lead to even more gross margin improvement.
Is Chewy's growth hitting a ceiling?
Chewy's mission is "to be the most trusted and convenient destination for pet parents and partners everywhere," which is a big goal. According to a recent survey by the American Pet Products Association, over 90 million U.S. families own at least one pet.
However, Chewy looks like it's hitting a ceiling in capturing this large opportunity. As of Q3, it had 20.5 million active customers. This was only up by a hair from the second quarter and was down from its peak active customer count of 20.7 million in the fourth quarter of 2021.
Chewy's profits are improving, as already noted. But it's still worth noting that margins remain razor-thin. The company's gross margin of 28.4% in Q3 is a record, but not spectacular. And while it does have real net income, its profit margin is just 0.8%.
Yes, Chewy is a business that's built infrastructure in such a way that it becomes more profitable with greater scale. That's great news for shareholders. However, if it doesn't grow its customer base, the company could fail to achieve the scale it's shooting for.
Should you invest in Chewy stock for 2023?
Here's one possible explanation for Chewy's lack of customer growth of late: the economy. Because of inflation and a slowing economy, management noted that fewer people are looking to add pets to their lives right now. But it's reasonable to assume the economy will improve in time and this headwind will eventually abate.
However, this macro-economic headwind for Chewy could keep blowing in 2023. According to a recent survey from The Wall Street Journal, 63% of economists believe a U.S. recession will happen next year. This could hold down Chewy's customer growth.
That said, Chewy does have other growth drivers in 2023, such as offering customers more options when it comes to the health of their pets. And it's launching advertising on its platform that could add incremental, high-margin revenue.
Moreover, Chewy's core business looks rock solid. Consider that in Q3, 83% of sales came from food and health categories -- categories that aren't considered discretionary. In other words, one would expect spending on Chewy to remain resilient in 2023 no matter what the economy does.
In conclusion, I would expect Chewy stock to perform in line with the market in 2023. It has opportunities, but it's also facing challenges. Cautious investors might wait for better customer growth before buying. But the strength of Chewy's core business may also limit its downside in the coming year, meaning those who really love this business might consider buying small pieces consistently with dollar-cost averaging.