What More Does Chewy Have to Do to Impress Investors?

Key Points

• Chewy's Q2 report last week showed a 14% jump in revenue but a 0.6% drop in active customers.
• Bears point to deteriorating fundamentals and say to avoid the stock until signs of sustainable bottom line growth reappear.
• For bulls hopeful that the turnaround story plays out and secular tailwinds kick in, the depressed sentiment around the stock is an opportunity.

Not even a consensus-topping second-quarter earnings report could save Chewy, Inc. NYSE: CHWY shares from sliding to a new 52-week low. The online pet products retailer is getting chewed up and spit out for a third straight calendar year after riding the pandemic e-commerce boom to $120.00 in early 2021. 

On Thursday, Chewy's stock dipped as low as $23.03 after the company posted Q2 results. Sales increased 14% to $2.8 billion, exceeding internal guidance due to solid order activity and demand for autoship service. Management delivered a surprise profit for the sixth consecutive quarter when Wall Street anticipated a net loss — but it didn't matter.

Like a distracted house cat, the market shrugged off the outperformance and kept its attention on Chewy's non-financial metrics. Active customers decreased by 0.6% to 20.4 million, a development some analysts think will persist as pet owners adjust to the economic environment. Management noted "a shift in consumer mindset toward being more discerning," which suggests that inflation is causing Americans to visit chewy.com less often. Essentials like pet food and medicines are in. Discretionary items like treats and toys are out.

Yet there's something to be said about customer loyalty. Although fewer people are shopping at Chewy than last year, those that do are spending more. It's certainly a better scenario than at brick-and-mortar rival Petco, where pet supply sales fell 9% last quarter. And as inflationary pressures moderate, disengaged pet parents will likely come crawling back to chewy.com for the superior selection and convenience.  

Should a 0.6% drop in active customers overshadow a 14% jump in revenue? As the stock gets dangerously close to erasing all of its post-Covid gains, this is just one of the things Chewy haters and lovers are tussling about. 

What Is the Bear Case for Chewy Stock?

In addition to the slight dip in active customers, Chewy bears are concerned about a 'trade-down' that appears to be impacting the retailer. With prices up across the board, management commented that customers are opting for lower-priced value merchandise. Since these products tend to carry lower margins, profits may continue to suffer. And since stellar growth and margin expansion propelled CHWY above $100, bears say to avoid the stock until signs of sustainable bottom line growth reappear.

While Chewy has been able to claw out small profits in recent quarters, in Q2, EPS was 20% lower than in the prior year. This is one mark of deteriorating fundamentals that bears say makes the stock a 'dog with fleas' — regardless of the longer-term outlook. Bears also point to the balance sheet's 1.3x debt-to-equity ratio. With debt the majority of the capital structure, digging out of a hole to generate growth may be more challenging. For value investors that may be tempted to 'buy low,' Chewy's lack of dividend is also a negative.

What Is the Bull Case for Chewy Stock?

Bulls argue that Chewy's near-term profit struggles are temporary. The company is facing a consumer spending slowdown from an unprecedented period of hyper demand when chewy.com was one of the only ways to get pet products. Inflation has only complicated matters. Lost in the post-pandemic hangover, however, is the fact that the pet category's e-commerce leader has grown revenue by approximately 200% and expanded its gross margin by 8% since 2019.   

As year-over-year comparisons get easier and economic conditions improve, Chewy will be better positioned to benefit from a growing pet supply market that is expected to see higher levels of online penetration. With roughly two out of three U.S. households owning a pet, the domestic pet industry is forecast to reach a record $143.6 billion this year and continue to expand from there. Chewy's focus on essential pet products and services, which account for more than 80% of sales, along with the recurring revenue generated by autoship, make it an attractive way to invest in long-term pet spending growth. 

Meanwhile, Chewy's push into higher-margin businesses could help improve its financials sooner than the market expects. The company continues to invest in pet medications and insurance to improve profitability and grab a bigger slice of the overall pet market. Earlier this summer, it rolled out its CarePlus pet insurance plans (in conjunction with Trupanion and Lemonade Pet) starting at $20 per month to address the impact of rising vet bills on its 20 million customers.  

Bottom line: Chewy has several challenges to work through as it adjusts to a normalized consumer spending backdrop and inflation. For skeptics who had grown accustomed to strong financials and customer growth, this makes it an execution story and a 'wait on the sidelines' stock. 

For optimists hopeful that the turnaround story plays out and secular tailwinds kick in, the depressed sentiment around the stock is an opportunity. Barring another major setback, the bottom may not be far away. Even the most bearish Wall Street price targets imply upside — and the $44 consensus target gives CHWY a long leash to run on.