Leading U.S. pet e-retail marketplace Chewy (NYSE:CHWY) made a splashy debut on Wall Street in mid-June 2019. The Chewy stock IPO was priced at $22 per share.
On the first day of trading, Chewy closed at $35 (up 60% from the IPO price) as investors drooled over Chewy’s opportunity to turn into the Amazon (NASDAQ:AMZN) of the bigger-than-you-would-think pet e-retail market.
Then, investors stopped drooling. They started looking at the numbers. About $3.5 billion in 2018 sales for Chewy. Gross margins of just 20%. Huge operating losses. And yet, up at $35 per share, Chewy was fetching a $15 billion market cap.
A 4-times trailing sales multiple for a company with just 20% gross margins and no profits? That’s steep. Investors quickly realized that. They started selling Chewy stock. And, once the selling started, it didn’t stop, as bearish momentum and sentiment took over.
Today, CHWY stock trades just a hair above its $22 IPO price.
Against that backdrop, Chewy is set to report third-quarter earnings after the bell on Monday, Dec. 9. This report is huge. Either it will affirm recent weakness in shares with weak numbers, and cause the stock to drop even further into the end of the year. Or, it will negate recent weakness in shares with strong numbers. If that happens, Chewy stock could soar into the end of 2019.
So, which way will CHWY stock swing after earnings? Higher. Here’s why.
Chewy Earnings Could Be Really Good
The qualitative and quantitative backdrops both support the notion that Chewy’s third-quarter numbers will be quite good, and that the company is positioned to have a huge holiday season.
Consider where we are today. Since late 2018, recession chatter and fear have dominated financial conversations. Naturally, that fear makes its way into the consumer landscape, where consumers act more cautiously. Now, for the first time in a year, that recession chatter is fading from the conversation, as U.S.-China trade relations improve and as U.S. stock market indices surge to all-time highs.
Consumers are taking note of this. They will start spending more, especially because it’s the holiday season and they are all working, sitting on huge savings, and have been getting raises all year long. What will they spend big on? Their pets, of course.
For several years now, the pet market has been one of the biggest growth verticals in the holiday spend pie, as more and more consumers are including their pets in their holiday shopping plans.
That trend didn’t all-of-a-sudden change this year. So this holiday season Chewy is sitting at the convergence of two huge tailwinds (a rebound in consumer spending trends, and a secular uptick in holiday pet spend). Naturally, this convergence likely powered big sales growth over the past few months and will continue to power big growth into Christmas 2019.
Importantly, the data supports this thesis. Non-store retail sales rose 14.6% year-over-year during the past three months, more than the 14.2% they rose over the prior three-month stretch. Meanwhile, Chewy has seen steady growth in U.S. online search interest, while Chewy.com has seen steady gains in web traffic share.
Big picture? Chewy’s third-quarter numbers should be strong, as should management’s outlook for the holiday quarter.
Chewy Stock Is Undervalued
Chewy stock has been overvalued. Now, it’s undervalued.
The U.S. pet food and supplies market measured $46 billion in 2018. Of that, 18% of sales came through the digital channel, for a pet food and supplies e-market size of $8.3 billion. Chewy recorded sales of about $3.5 billion, putting the company’s pet e-retail market share at over 40%.
In other words, Chewy dominates this market, much like Amazon dominates the broader eCommerce market with nearly 50% share of the U.S. eCommerce market.
That’s good news for Chewy because the pet e-retail market is in the early stages of big growth. The pet food and supplies market projects to grow at a 4% annualized pace going forward, driven by a secular uptick in how much consumers love (and spend on) their pets.
At the same time, eCommerce penetration rates in this space are expected to move materially higher, towards 25% by 2022 and potentially 30% by 2025.
If you put all that together, U.S. pet e-retail sales should grow at a 10%-plus rate into 2025. Assuming Chewy does become more Amazon-like and leverages its first mover’s advantage and scale to gain even more scale, then Chewy reasonably projects as a 15-20% revenue grower into 2025.
Gross margins will likely settle around 30%, which is where Petco’s gross margins were a few years back. The opex rate should simultaneously fall with scale, from today’s 27% rate to a more normal ~20% rate over time.
Assuming all that, $2 in earnings per share seems doable for Chewy by 2025. Based on a consumer discretionary sector-average 21-times forward earnings multiple and a 10% annualized discount rate, that equates to a 2019 price target for Chewy stock of $26.
Bottom Line on Chewy Stock
Chewy stock is a long term winner that suffered from too much hype in its IPO pop. Most of this hype has since left the stock. Now, shares are trading with arguably too little hype. Strong third-quarter numbers and a favorable holiday quarter outlook should breathe life back into shares. As such, Chewy stock seems well-positioned for a nice holiday rally.
As of this writing, Luke Lango was long CHWY.
