Not many retailers have been able to fight back against industry behemoths like Amazon and Walmart. Chewy (CHWY 2.99%) is one of the few companies that has managed to carve out a corner of the market for itself.
It's done so by becoming a top e-commerce destination for pet owners, a sector of the retail industry expected to see strong growth this decade. With over 20 million loyal customers, Chewy has a big opportunity to take advantage of this industry tailwind.
Customers love Chewy, and it has grown its revenue at a quick pace. But for years, that growth has come at the cost of profits. Even with over $10 billion in annual revenue, the bottom line is thin, leaving investors skeptical of the company's earnings potential as its business matures. Here's why their concerns may have some validity.
Loyal customers, recurring revenue
Chewy has won over millions of pet owners in North America. It tries to differentiate itself by going above and beyond with its convenience and service (and is well-known for sending flowers to customers who have recently lost a pet). You won't find that personal touch at Amazon.
The company's customers are loyal. Though its active customer count declined slightly in the fiscal 2023 second quarter (ended July 30) to 20.6 million, revenue was still up 14% for the period due to higher sales per active customer.
The average active customer spends $530 with Chewy each year. A big driver of that spending is the company's autoship feature, which puts pet food and supplies on a subscription-like schedule for customers looking for ease and efficiency. Last quarter, over 75% of Chewy's revenue came from its autoship feature.
At its already massive scale, you might think Chewy is running out of pet owners to target -- how big can the pet industry be? Very big. By 2030, analysts expect the market to hit $275 billion, up from under $100 billion in 2020. If Chewy just retains its market share, it could theoretically more than double its revenue over the next 10 years.
A path to profitability? Not so fast
On $2.8 billion in fiscal Q2 revenue, Chewy had a gross margin of 28.3%. This looks quite strong for a retailer and implies the company has a path to profitability (it's essentially operating at breakeven with a 0.7% profit margin through the first half of fiscal 2023) once it reaches a sufficient scale.
But look more closely at Chewy's income statement, and an important caveat emerges: The company reports its fulfillment costs under the "selling, general, and administrative" expense line instead of cost of goods sold.
From my perspective, fulfillment costs are fundamental to Chewy's operations since they scale along with its e-commerce business. A cost that goes up with revenue should be included in the gross profit calculation, even if auditors don't take that approach. Wherever it gets classified, these fulfillment costs are still a roadblock to any major profit generation.
Even worse, we don't know how much of Chewy's operating expenses come from its fulfillment costs. Management doesn't disclose an absolute number. Over the last 12 months, Chewy's overall operating expenses totaled $3.0 billion. A good chunk of that likely comes from its fulfillment operations, meaning Chewy's true gross margin may be much lower than 28.3%.
Data by YCharts.
Why I am avoiding the stock
Even though the company appears to have a long growth runway, I would avoid buying Chewy shares due to its obscure margins. If we look at its free cash flow -- another measure of profitability -- Chewy has generated $339 million over the past 12 months. Great, right?
Well, $209 million of that came from stock-based compensation, which is going to dilute shareholders. Another chunk came from working capital benefits, which shareholders can't take home to the bank. Both of these line items will help Chewy manage its cash flow -- which is an advantage -- but it does not create much in value for shareholders. Investors should take this into serious consideration.
Even at a huge scale and over $10 billion in revenue, Chewy has struggled to generate much in true profits. Until that changes, you should avoid buying Chewy stock.
