They say you can't teach an old dog new tricks, but Chewy (NYSE: CHWY), the online pet products seller, hopes to prove that an old business model can work new magic.
Nearly a generation after Pets.com became one of the most memorable busts of the dot-com era, Chewy is seeking to show that, in an Amazon (NASDAQ: AMZN)-dominated e-commerce ecosystem, there's still room online for a pure-play pet retailer.
The company, which is majority-owned by brick-and-mortar pet retailer PetSmart, is set to go public Friday, and underwriters just raised their price range for the stock from $17-$19 to $19-$21. This gives the company a valuation of $8.4 billion at the top of that range. It's a sign that shares are in high demand ahead of the company's public debut.
Here are a few key fundamentals investors should know about the stock:
- Revenue growth is impressive. According to its estimates, Chewy's sales jumped 45% in the first quarter to $1.1 billion.
- Revenue growth is slowing down. Last year, Chewy's sales increased by 67.9% to $3.53 billion. In 2017, revenue more than doubled to $2.1 billion, up 133.8% from the $900.6 million it recorded in 2016. Before 2018, revenue had doubled every year since Chewy was founded in 2011.
- The company is unprofitable. Last year, it had an operating loss of $267.8 million, or 7.6% of its revenue, which was an improvement from 2017, when it reported an operating loss of $337.9 million, or 16.1% of revenue. In the first quarter of 2019, Chewy had an operating loss of $30.3 million, or 2.7%, significantly better than the year before.
- Petsmart keeps voting control: PetSmart bought Chewy in 2017 for an estimated $3.3 billion in the largest-ever acquisition (at the time) of an e-commerce business. PetSmart plans to remain the majority shareholder through its ownership stake and a dual-class share structure.
How Chewy sees the market
Chewy is the largest pure-play online retailer of pet products and sees its singular focus on pet products as an advantage over broad-market retailers like Amazon and Walmart (NYSE: WMT). The company recruits pet lovers as its customer service representatives and gives them extensive training. It sees excellent customer service as a core competency and a necessary way to differentiate itself from competitors both online and offline. Chewy prides itself on its "high-touch" customer service, offering personalized touches like handwritten holiday notes and welcome cards, original pet portraits, and even flowers to the family of a recently deceased pet. The company calls this the "WOW" experience, and it's a key reason why it has a net promoter score of 86, or the percentage of its customers that would recommend the brand to a friend. That also helps explain why its revenue growth has skyrocketed since its founding in 2011.
The opportunity in pet products is abundantly clear. As more Americans do their pet shopping online, the market will see secular growth. According to third-party estimates, online spending on pet products in the U.S. totaled $6 billion in 2017 and was expected to grow by a compound annual rate of 17% through 2022. Today, the U.S. pet products market is worth $70 billion and is growing by 4.2% a year as more Americans become pet owners and spend more on their pets. The industry has the advantages of being both recession-proof and lacking seasonality, giving it favorable dynamics for a company like Chewy to build a long-term business.
Though Chewy is not currently profitable, the company has seen significant improvements in its gross margin, which rose from 17.5% in 2017 to 20.2% in 2018, and from 19.6% in the first quarter a year ago to 22.9% in the first quarter of 2019. The company also said it's seen improving unit economics through customer retention as sales from its existing customer base rose 20% last year.
Management said that customer cohorts also become more profitable each year after they start with Chewy and reach profitability by their second year. In their first year, the company loses money on new customers due to customer acquisition costs and the cost of their initial order. Autoship customers, whose orders come through a subscription based on their pre-determined intervals, made up 67.1% of the company's sales last year. The autoship business acts as its own competitive advantage, creating a barrier to entry for the company and a sustainable, easily predictable revenue stream. It generates high-margin business because Chewy can more easily prepare for those orders.
The risks of the Chewy model
Direct selling online, as Chewy does, has proven to be a very difficult way to build a profitable business. Brick-and-mortar retailers often complain that online sales are less profitable than their in-store equivalents as online retail often requires the seller to pay for things like shipping and returns, customer service, and increased advertising as there isn't a physical storefront to bring customers in off the street or in from a mall.
Even Amazon, the titan of American e-commerce, has only recently begun to generate a profit from its domestic e-commerce business largely because of third-party services like its marketplace and fulfillment, which handles shipping and returns for its marketplace sellers.
Wayfair (NYSE: W), a pure-play online seller of home goods, was founded in 2002, nine years before Chewy, and is still not profitable. However, that company is worth $14.8 billion today and is still growing quickly, with revenue increasing 43.6% last year to $6.8 billion. Fast-growing online retailers like Wayfair and Chewy have chosen to spend aggressively on sales and marketing in order to drive top-line sales.
Advertising and marketing costs made up 11.1% of Chewy's revenue last year, and Wayfair spent a similar percentage of its revenue, 11.4%, on advertising last year. Both companies would be profitable after backing out a majority of their marketing spending, or if they sharply reduced it. Chewy has acknowledged in its risk factors that the company may not achieve profitability.
In addition to the challenges in the direct selling model, Chewy also faces increased competition in the pet products industry, which has attracted interest from companies big and small due to its steady growth and its resistance to recessions. Last year, Amazon launched its own pet products brands and said it would expand its offerings in the category, signaling its interest in the space. Earlier this year, Walmart launched an online pet pharmacy, is adding veterinary clinics to its stores, and is expanding its line of private-label pet products.
Merger and acquisition activity has also been hot in the sector. General Mills acquired Blue Buffalo, a maker of natural pet foods, for $8 billion last year, and JM Smucker bought Ainsworth Pet Nutrition, the maker of Rachael Ray Nutrish, for $1.9 billion last year.
Considering all of the activity in the sector, even if Chewy succeeds in proving the opportunity in pet products e-commerce, the company will be far from alone in the space, and the additional competition could easily translate into narrower margins.
Can this dog hunt?
Chewy has succeeded thus far in building a substantial customer base, with more than 10 million active customers, but its slowing revenue growth, lack of profits, direct online selling model, and rising competition could pose challenges for investors down the road.
We'll learn more when the stock begins trading Friday. Seeking a valuation around $8 billion, Chewy clearly believes it can run with the big dogs.
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