The demise of Chewy (CHWY -0.14%) at the hands of Amazon (AMZN 0.56%) was prophesied long ago. Consider this 2019 headline from Business Insider: "Fresh off its IPO, Chewy might be the next company to get crushed by Amazon."
I'm singling out this headline because it clearly communicates prevalent investor sentiment regarding Chewy at the time of its initial public offering in 2019. Some might even still feel that way. But sales are up 46% year over year through the first three quarters of 2020, so it's clearly resonating with consumers. And the stock has been awesome: up almost four times from its IPO price.
Here's why everyone's talking about Chewy stock, the niche e-commerce player thriving in Amazon's shadow.
Image source: Getty Images.
The growing customer base
Chewy is commendably attracting and retaining customers. Recently reported results show the company added 1.2 million net new customers in the third quarter alone. It now has 17.8 million active users, up nearly 40% year over year. And year to date, it's gained 5.1 million new customers, highlighting the value of e-commerce during the COVID-19 pandemic. The good thing for Chewy shareholders is that e-commerce tends to be a sticky habit, not a temporary behavior modification.
But regarding e-commerce, why would someone choose Chewy over Amazon, especially when people are already using Amazon for other purchases? It might have something to do with the personal customer service Chewy provides. The company is known for using a pet's name when communicating with customers, and it even sends surprise personalized gifts from time to time. This strategy gives the appearance that Chewy truly cares about your pet. Since pet owners love their furry friends, they're drawn to others who at least appear to love them, too.
Whatever the reason for its appeal, one thing's for sure: Chewy is not being crushed by Amazon.
Image source: Getty Images.
Recurring revenue
Speaking of Chewy's customer base, 69% of sales are derived from Autoship customers. Pet owners more or less know what their pet needs will be and how long supplies should last, so setting up automatic shipments makes sense. And Chewy incentivizes customers to enroll in Autoship because it's beneficial: The company can more accurately predict upcoming inventory needs. It's not true recurring revenue; customers can cancel anytime. But it makes this business easier to run.
Chewy customers are incentivized to enroll in automatic shipments by receiving a 5% discount on their orders. And Chewy is working on more ways to drive customers toward automatic shipments. For example, it just launched a telehealth service for pets called Connect With a Vet. The service will be free but only available to Autoship customers, providing holdout customers further incentive to enroll in automatic shipments.
While many e-commerce retail companies enjoy some level of repeat business, few are developing an ongoing relationship with customers the way Chewy is.
An overvalued stock?
These are a couple of reasons people are talking about Chewy's business. But when it comes to its stock, the valuation is often the topic of discussion. People wonder if it's overvalued.
It's a fair question. Just consider the price-to-sales (P/S) valuation of Chewy stock compared to Amazon.
CHWY PS Ratio data by YCharts.
There are multiple ways to measure a stock's valuation. The P/S ratio is just one, and shouldn't be used in isolation, but it's helpful for our purposes here. To calculate, take a stock's market capitalization (the value of all the shares combined) and divide by the company's trailing-12-month revenue. Higher revenue growth typically warrants a higher P/S ratio, and vice versa.
As the chart shows, Chewy stock is more expensive than Amazon stock on a P/S basis. Chewy grew Q3 revenue by 45% while Amazon grew it by 37%. Therefore, a higher P/S ratio for Chewy seems warranted in isolation, considering its faster growth. But there's more to it than that. One could argue Amazon's revenue is more valuable than that of Chewy.
Here's what I mean: Over the last 12 months, Chewy has generated free cash flow (FCF) of $15.5 million on nearly $6.5 billion in revenue -- a paltry margin under 1%. By contrast, Amazon has generated $29.5 billion in FCF over the last 12 months -- over an 8% FCF margin. Given all the cash Amazon generates, does it really make sense for Chewy to trade at a premium to Amazon stock?
As you can see, when assessing the valuation of Chewy stock, it can be argued both ways. Most stocks are that way, because valuation metrics measure a moment in time: now. But to truly know if Chewy stock is overvalued, investors must envision what this business could become in time. That skill takes work to develop but is well worth it for long-term investors.
