Chewy’s Pet Industry Rerating (Downgrade) (NYSE:CHWY)

REVIEW

Last time we discussed Chewy (NYSE:CHWY) in December 2023. In less than eight months, the stock is up 70% since we issued a buy rating of $17.5. Despite the stiff competition, we think Chewy should be capable to withstand this harsh environment, and the market response indicates that the company has probably established itself in this sector.

Q2 2024 performance

Margin improvement

The company has demonstrated its ability to strengthen its margins once again in Q2, 2024. This indicates that management’s plan is effective. The company has made an effort to differentiate itself from formidable competitors like Amazon (NYSE:AMZN) by offering services like pet insurance and pet hospitals. As a result, we observed that its margin increased and concluded that it is driven by the increase in net sales for active client values.

Customer base challenges

However, the customer base continued to decline. Even as the company grows in new markets like Canada and offers more items, the number of customers fell to 20 million this quarter. In addition, the autoship company’s customer sales trend, which grew by 5.8% but at the slowest pace in the last two quarters, indicates that it still has a strong and devoted customer base, but it is possible that the company have had trouble attracting new customers, especially in the US.

Management attributed this to the challenging industry environment caused by high inflation and anticipated an improvement by 2025. Management reported that while the abandonment rate decreased, the overall pet adoption rate increased. These may be the first signs of normalization in the sector. We speculate that this trend could follow the same trajectory as the inflation trend. The position of US consumers may have improved over time as US inflation continued to cool.

However, the Conference Board reports that while high-income consumers (over $100,000) continue to show resilience, those with low incomes (between $15,000 and $24,000) show a continued downward trend. Therefore, given the importance of younger consumers to the pet economy, we can anticipate that the growth outlook for the pet sector will continue to be sluggish.

Chewy anticipates a re-acceleration in revenue growth, driven by new product offerings and monetization efforts such as sponsor ads, beginning in Q3 2024. By monetizing site and app traffic, the company currently expects to restart its the boost to revenue growth. This was a smart strategy to allow the company to focus on its existing ecosystem when growth opportunities are few, giving it more ammunition for when the pet industry starts to expand again.

ASSESSMENT

Given that the pet sector may not fully recover, Chewy continues to face challenges in growing its customer base. The stock’s current rise is primarily due to the company’s better profitability and margins, which essentially indicate that it is no longer stressed. Its shares currently trade at EV/S and P/S ratios comparable to the sector median as a result.

When comparing Chewy’s stock to its peers in the pet industry, it trades at a premium due to its P/S ratio. The company’s stock has finally outperformed its competitors, including Petco (WOOF), indicating that the market has recognized its dominant position. As a result, we believe the stock is likely a fair value in the near term given its existing industry position.

Risk

Competitive landscape

In the long term, the business needs to differentiate itself from smaller competitors like Farmer’s Dog and Amazon.

We appreciate Chewy’s efforts to differentiate itself through vertical integration. Chewy already operates six pet hospitals and plans to launch more. Chewy boasts a 24/7 customer service team with training in pet care and supplies. As a result, it could respond with greater professionalism than Amazon’s AI agent or its customer support staff. In addition, they offer their own CarePlus insurance plan, which covers vet visits by licensed professionals. As such, customers who enjoy a one-stop shopping experience may choose it over Amazon.

However, big competitors like Amazon usually offer lower costs than Chewy. Thus, we believe that this could be one of the causes of the company’s halt in expanding its clientele. During Pet Days 2024, Amazon increased its revenue by 6.3%.

In addition to having a larger user base and strong delivery capabilities, Amazon now sells pet items under the Amazon Basics brand. Amazon can offer its private label at a competitive price by leveraging its user base. Therefore, Chewy should face pricing pressure as a result of this. Therefore, we believe that Chewy’s benchmarks are still not very strong, even though Chewy is working on vertical integration and trying to offer additional products to its customers.

Instead, smaller competitors want to differentiate themselves from Chewy by offering more personalized goods and services. To connect with pet owners on a more emotional level, they also prefer to sell on their websites and advertise on social media. Given that fresh food must be delivered on time, Chewy may not have an advantage over its smaller competitors in this space.

Chewy may not be very competitive unless it chooses to develop its product, unlike smaller competitors who ship their product directly. As a result, we like to wait and evaluate Chewy’s competitive advantage when we see Chewy offering additional services and goods.

Conclusion

We believe Chewy continues to lead the pet industry, but to differentiate itself from the competition, it needs to expand its range of services and products. We believe the recent increase in share price indicates that the market now recognizes the company as a leader rather than one in crisis. While we believe Chewy has room for long-term growth, we think the recent share price rally is more fair given its future growth prospects. Therefore, we degrade it to maintain.