It’s been an incredible year for the stay-at-home trade, with several tech names like DocuSign (DOCU), Zoom Video (ZM), and Peloton (PTON) putting up incredible returns. However, the Internet Retail names like Amazon (AMZN) and Chewy (CHWY) have also benefited massively, with the latter soaring over 140% year to date. Chewy’s outperformance has dwarfed the returns of the S&P 500 (SPY), as the company posted record sales in Q1, a 2200-basis point acceleration sequentially from Q4 2019. Unfortunately, while this is exceptional growth, we should see a material deceleration in the following quarters with the stock now up against tough sequential comps. Therefore, while I love the business long term, I believe investors would be wise not to chase the stock here above $72.00.
(Source: Company website)
Chewy is getting ready to report its Q2 results on September 10th, and if the metrics are anything like the Q1 report, we should see another blowout quarter. During Q1, the online pet product retailer reported quarterly sales up 46% year over year to $1.62 billion, and 1.6 million net active customers added in the quarter. This came in at double the quarterly pace in FY2019, with COVID-19 certainly helping results. This is because shopping for one’s favorite pet brands wasn’t nearly as easy with shelves bare at some stores, and many consumers weren’t interested in heading to stores at all. As of quarter-end, the company had 15 million active customers, up ~32% year over year. It’s also encouraging to see that sales per active customer have increased at mid-single digit levels (6.6%), so both the average ticket and the customer base are growing rapidly.
(Source: The Canadian Press, GlobalNews.ca)
The other tailwind working in Chewy’s favor in Q1 was a surge in animal adoptions and fostering, with Sarah Brasky of Foster Dogs Inc. noting that demand for dogs was at an all-time high. With Chewy’s online retail option providing the easiest way to pick up pet products and an increase in pet ownership in Q1, it’s no surprise that it took the pet market by storm and was able to post record results. This is great news long term for the company, as online shopping is a very sticky experience. However, while it’s likely we’ll see several thousand new customers become long-term Chewy customers, it’s worth noting that this is likely the best it can get for the company in terms of future tailwinds. Therefore, even though Q1 certainly helped to accelerate the migration to Chewy and its brand recognition, I believe it will be difficult to replicate this growth going forward unless we get a second wave of the virus that forces many consumers to stay home. Let’s take a look at the company’s growth metrics below:
(Source: YCharts, Author’s Chart)
If we look at quarterly revenues, the results were exceptional. Chewy saw revenue grow 46% year over year and 19% sequentially, the strongest quarter of sequential growth we’ve seen since Q4 2018 ($1,088 million vs. $876 million). If we look ahead to Q2 and Q3 2020, we are expected to see continued new all-time highs in quarterly revenues. Q2 revenue estimates are currently pegged at ~$1.64 billion, translating to 43% growth, while Q3 revenues are sitting at ~$1.66 billion, which implies a 35% growth rate year over year. These are exceptional growth rates for a non-tech company, and they place the company on the top 150 growth list among the US stocks I follow. However, while the continued new highs in quarterly revenue are impressive, the recent acceleration was not enough to reverse the downtrend in the two-quarter average revenue growth rate. In fact, we should see a material deceleration in this growth rate starting in Q3.
(Source: YCharts, Author’s Chart)
As we can see above, we saw a sharp acceleration in the two-quarter revenue growth rate (green line) in Q1, with a 300-basis point improvement sequentially (35% vs. 32%). The Q2 results are expected to be even more impressive, with a sequential acceleration of 900 basis points based on current estimates (44% vs. 35%). However, this trend higher in revenue growth rates is not expected to last. In fact, Q4 2020 estimates are forecasting that the two-quarter average revenue growth rate will slip back down to Q4 2019 levels at 32%. Given that the market is forward-looking, I believe that Q2 results are already mostly priced in here, and the more important metrics to look at are the H2 2020 results. Therefore, I would not be surprised if we saw a “sell on news” or any further strength sold into when the company releases its Q2 report.
Some investors may wonder why one would use a two-quarter average revenue growth rate, and the reason is to normalize for lumpy quarters. This is exactly what we saw in Q1 2020, given the massive tailwind from the pandemic, and while this was a dramatic tailwind for Chewy’s business, the growth rates are not expected to last. In fact, despite the largest tailwind we’ll likely ever see for the company, the two-quarter average revenue growth rate was unable to break out from its 2-year downtrend, and this figure should likely continue to head lower over time. It’s important to note that this is not a bearish development, and it’s completely normal to see deceleration, as companies cannot keep growing at 50% forever. However, the current valuation is priced for a stock seeing material acceleration, and this is simply not the case.
As we can see from the chart above, Chewy is currently trading at 5.2x sales, a hefty price to pay for an online retailer with sub-25% gross margins. In the most recent quarter, the company reported gross margins of 23.4%, a slight contraction from the 24.1% reported in Q4 2019. While there’s nothing wrong with a two-quarter average gross margin rate of 23.80%, it is one of the weakest in the Internet Retail industry group. If we look below, we can see that Amazon has a two-quarter average gross margin of 41.1%, while Wayfair (W) has a two-quarter average gross margin of 27.80%. Therefore, even though I expect that Chewy’s gross margin will improve over the long run, it’s hard to justify the stock trading at roughly the same revenue multiple as Amazon (5.26 vs. 5.56) and a large premium to Wayfair given that it has the weakest margins.
(Source: YCharts, Author’s Chart)
Some investors that valuation is useless in a bull market and that Chewy still has a large runway for growth. While I would agree that valuation is not the best timing tool out there, the technical picture corroborates the view that the stock is getting ahead of itself. As we can see, Chewy has had quite a bit of trouble in the past when it’s pushed more than 30% above its 100-day moving average (pink line), and the stock has typically corrected at least 15% over the following two months after getting this extended. Currently, the stock is more than 45% above its 100-day moving average above $72.00, and this suggests that the reward-to-risk is no longer favorable here. It’s important to note that this does not mean that Chewy can’t go higher; it merely means that any further upside above $72.00 has a high probability of being retraced. Therefore, I believe that any rallies above $74.50 before Q4 would be an opportunity to book some profits.
While Chewy is an exciting growth story with significant long-term potential as the market leader in the online pet products space, I believe the easy money has been made here with the stock up over 140% year to date. The fact that we should see a material deceleration in revenue growth following Q2 is a negative development that could weigh on valuation a little, as Chewy is currently trading at a valuation more suited to a company seeing a long-term acceleration in revenue growth rates. Based on the material deceleration of 550 basis points in the two-quarter average revenue growth rate expected in Q3, and lofty valuation, I believe investors would be wise not to chase the stock at current levels. If the stock were to head above $74.50, I think this would be a good spot to start booking some profits.
Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.