Online pet retailer Chewy (CHWY 2.99%) enjoyed a period of skyrocketing pet ownership during the pandemic. Revenue soared 24% in 2021 as pet owners turned to Chewy for its attractive prices and convenient shipping options. The stock soared as well, peaking at around $120 per share in early 2021.
The bill is now coming due. Demand was pulled forward by the pandemic, with new pet households forming that otherwise would have remained pet-free or delayed getting a pet. Even as it wins market share, Chewy is struggling to retain its customer base.
Sluggish growth
Chewy managed to grow revenue by 4.2% in the fourth quarter of 2023 thanks to heavier spending from its active customers, but the number of active customers declined. Chewy ended the year with 20.1 million active customers, down from 20.7 million at the end of 2021 and down 1.6% year over year.
Chewy is profitable, but just barely. The company managed a net income margin of just 1.1% in the fourth quarter, and that was largely due to interest income on the mountain of cash it keeps on its balance sheet. On an operating basis, Chewy reported a loss for both the fourth quarter and the full year.
While Chewy expects pet industry trends to revert to historical norms in 2025, this year will be another tough one for the company. Chewy expects pet household formation to remain muted. The company also doesn't anticipate a tailwind from higher pricing.
Chewy is working to cut costs and become more efficient, but the core retail business is inherently a low-margin affair. Chewy's gross margin was just 28.4% in 2023. When it comes to things like dog food that pet owners must buy over and over again, price is a big factor, and competition is fierce.
A critical growth initiative
According to a report from the American Veterinary Medical Association, the most important determining factor for pet owners choosing a vet is expertise. The smallest factor is price. The situation is flipped when it comes to buying medication, either online or in-store.
Chewy already operates a pet pharmacy business, but that business is subject to the same price sensitivity as the core retail business. While the pet pharmacy unlocks an additional market for Chewy, it likely won't help much to boost the company's margins.
What could help is Chewy's recent foray into the vet clinic business. Chewy sees a $25 billion opportunity in veterinary care. Importantly, the company expects the vet care business to have meaningfully higher margins than the company as a whole.
Chewy will start slow. The first vet clinic is set to open soon, and the company could open as many as eight clinics in fiscal 2024. If these early clinics perform well, the company has the potential to open a large number of locations across the United States in the coming years.
On top of providing a higher-margin source of revenue, Chewy's vet clinics can drive sales for the retail and pharmacy business while expanding the brand's reach to new customers. While retail will remain Chewy's core business, the Vet Care business could one day contribute a significant portion of the company's profits.
A beaten-down stock
It will take years for the Vet Care business to start contributing meaningfully to Chewy's top and bottom lines, but if it's a success, it could drive Chewy's margins higher in the years ahead. With the pet products industry struggling to grow, unlocking this new opportunity is critical for Chewy to grow its profits over time.
Shares of Chewy have been hammered over the past few years, down about 85% from the pandemic-era peak. The stock is expensive relative to generally accepted accounting principles (GAAP) earnings, but free cash flow tells a different story. With a free cash flow of $343 million last year, Chewy stock trades for about 21 times this metric.
That valuation makes sense if you assume Chewy will find a way to grow free cash flow. The core retail business can deliver some growth as Chewy boosts efficiency and ekes out some revenue growth, but the higher-margin Vet Care business looks like the company's best opportunity. If it works, Chewy's stock could be in for a big recovery down the road. If it doesn't, Chewy will remain a low-margin retailer, and the stock will likely remain under pressure.
