What happened
Shares of pet products e-commerce company Chewy (CHWY -2.54%) performed much better in the second half of 2022 than in the first half. Whereas it fell 41% in the first half of 2022, it gained 6.8% in the back half and outperformed the 1% gain for the S&P 500, according to data provided by S&P Global Market Intelligence.
Going into 2023, I believe the worst is over for Chewy. But that may not necessarily lead to market-beating gains. Here's why.
So what
As the chart below shows, the market seems to be valuing Chewy stock based on revenue growth. When sales growth spiked in 2020, so too did Chewy's price-to-sales (P/S) valuation. But net sales for Chewy through the first three quarters of 2022 are only up about 14% compared to the comparable period of 2021 and, hence, Chewy's valuation and stock price have dropped.
CHWY Revenue (Quarterly YoY Growth) data by YCharts
Now trading at just 1.6 times trailing sales, Chewy stock is cheaply valued, which could keep it from dropping much further in 2023.
Moreover, it's important to keep in mind that Chewy has something many of its growth-stock peers lack: real profits. Thanks to the automation of its fulfillment centers, the company's been able to expand its gross profit margin, trickling down to net income on the bottom line.
Through the first three quarters of 2022, Chewy reported cumulative net income of $43 million. That gives it a thin margin of just 0.6%. But it is profitable nonetheless, which gives the stock a solid foundation to mitigate further downside.
Now what
I would, however, argue that Chewy stock will be hard-pressed to beat the market average in 2023 and beyond without reinvigorating top-line growth. Consider that the company ended 2021 with 20.7 million active customers. But as of the end of the third quarter of 2022 it had only 20.5 million active customers.
This is concerning because, when it went public in 2019, Chewy cited a report from the American Pet Products Association that showed that 85 million households in the U.S. owned at least one pet. And according to a more recent report from the American Pet Products Association, pet ownership has increased since then, jumping from 67% of households to 70% of households.
In other words, it doesn't seem like Chewy should be struggling to find new users. But it is. Unless this reverses in 2023, the stock could be stuck in neutral.
The caveat here is Chewy can generate more revenue from existing customers. For example, it's been focusing more on pet healthcare products, which could drive more revenue growth. And it's been experimenting with ads lately on its platform, which could lead to a higher-margin revenue opportunity.
I still believe that active customer growth is the easiest path for strong business performance and consequently market-beating gains for Chewy. Therefore, that's what I'd be focused on when the company reports financial results for the fourth quarter of 2022, which will likely be in March.
