Chewy's Competitive Advantages

In my 10/15/2019 post I mentioned that I passed on Chewy and Uber. Over the past few weeks I ended up buying into both.

Here’s a thread I recently tweeted out on Chewy (CHWY). It's a hypothesis of Chewy's "flywheels". I am definitely not wedded to the idea so this is an attempt to crowd-source my thinking process.

1/n. Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft)$CHWY pic.twitter.com/FgzJLcD46L

— mspacey (@mspacey4415) December 12, 2019

For your convenience, here is the expanded thread (lightly edited and reformatted for blog).

Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft):

To fend off Amazon, we have to answer how the value chain is different and how those pieces fit together in a way that competitors: a) can't copy, b) not willing to copy.

I think the answer is Chewy's vertical Focus strategy.

Start with right hand side of diagram:

• Niche focus allows Chewy to optimize supply chain (e.g less product variation means easier arrangement/picking at fulfillment centers .. saves space/time/cost..etc)
• Chewy can invest cost savings into customer service (focus strategy reinforces this. e.g knowledgeable reps)
• Good service drives growth/retention. More Autoship customers enhances predictability -> more efficiency. (See original tweet for screenshot of management comments on this topic)
• Reinvest that saving into service = closes the loop on right side of diagram

Move on to left side of diagram:

• CHWY has built up a lot of fixed costs (fulfillment centers..etc). 
• Customer experience drives growth. 
• Growth + fixed cost = operating leverage & economy of scale. 
• Reinvest cost savings into customer service closes the loop

We are already seeing this reflected in CHWY's financials:  more active customers, higher % of Autoship customers, higher gross margins..etc. 

Again, I think it's all enabled by focus strategy, which won't be matched by Amazon.

Feedbacks and Conclusion

Overall reactions to the thread suggest that people are quiet negative about Chewy (even after the stock's recent run up). This makes me uncomfortable as I don't consider myself a contrarian.

The most notable response is from @CharlieZvible. He argues that CHWY's limited TAM means its margin needs to be more than low/mid single digits to justify valuation. He questions if that can be achieved.

"...The TAM is pretty well defined. $65bn if I remember correctly. Remaining share split mostly between wmt, cost, tgt, Amzn, pets. Didn’t look at Q3 but guessing $ sales added still flattening out. Think you need HSD margins to be good stock-high for consumables"

This is definitely a good point that needs to be considered. I'm inclined to disagree after doing some basic calculations. Here's how I think about it.

• At the time of this writing, CHWY trades at about $29/share. This represents <$12bn enterprise value. 
• CHWY is on track for $5bn of revenue a year and growing ~37% for the year ending 1/31/2020.
• They can easily reach $10bn revenue in a few years. A 5% EBIT margin on that is $500mm. CHWY would be trading at 24x EV/EBIT. 
• I would not be surprised that in 5 years it's more like $15bn revenue. At the same 5% EBIT margin, the current price implies ~16x EV/EBIT.
• Well known consumer stocks usually trade at high multiples so these are not far fetched.  

Going back to the TAM limitation. A $15bn revenue would imply 25% of the $60bn TAM cited. That sounds like a lot. Too much? I'm not sure. The whole point of the "flywheel" discussion above is to assert that Chewy's competitive advantages reinforce themselves overtime, so that the company gets stronger relative to competitors, and thus can grab a disproportionately large market share.

It's also possible that the $60bn TAM is not fixed, but in fact expanding due to secular trends ("humanization of pets"). It also seems logical to me that the convenience of e-commerce should expand TAM by converting previous non-consumers. New product innovations is another factor that can increase market size. Along that line of reasoning, I would note that the above is not counting the pet healthcare business.

So I'll leave off here. I bought Chewy under $26/share, as soon as I saw it pop above MA50 on huge volume. The discussion above was to decided whether I should add, hold, or exit. My decision, at least so far, is to hold.