STOCK | 10/03/20 FRESH LOOK

CHEWY INC. GREEN YELLOW RED LIGHT LIGHT LIGHT (TICKER: CHWY) LBIR Recommendation

Stock Price: $56.55 (10/02/20) Company Size: $23.3B Author: Garvit Bhandari

Company Rank: 366.0 Sector: Consumer Industry: Internet

Chewy Inc. is the largest pure-play pet e-tailer in the US offering pet food and treats, pet supplies and pet medications, other pet-health products, and pet services.

IN THIS FRESH LOOK WE’LL COVER:

 Summary of the Business Chewy Inc. is the largest pet e-commerce company in the US. Grab-and-Go

 Recent Developments THESIS CHWY achieved record net sales growth and customer additions in Q220 benefitting from increase in online adoption due to An investment in CHWY is a play on COVID-19. the growing online penetration in the pet market. CHWY is the largest  Competitive Environment pure-play pet ecommerce company in The pet e-commerce industry is highly the US. It is very well positioned competitive. CHWY has so far successfully given its expanding customer base, differentiated itself by providing a large unique customer engagement, and product selection, competitive pricing, and strong recurring revenue streams. exceptional customer service. However, low gross margin and lack  Conclusions/Recommendations of profitability is a concern. While opportunity is large, we are concerned about low margin and lack of profitability. The gross margins are in low to mid 20s, significantly below the usual

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0.94 STOCK: CHWY | 10/03/20 FRESH LOOK

Data as of 10/02/20 unless specified

Revenue Fwd $6.8B Enterprise Value: 23.4B Market Cap: 23.3B (TTM): ($5.9B) Fwd (TTM) 3.4x YTD Return: 95.0% RSI: 50.7 Price/Sales: (3.9x) Gross Margin Revenue Growth 24.2% 39.7% ROIC (TTM): (66.6)% (TTM): (TTM, YoY): 200-day Moving 52-Week High: 74.84 52-Week Low 20.62 47.7 Avg.

EBITDA $(17.1)M CFO $68M FCF $(26)M

Insider Transactions (2020): Insiders sold ~10.1M shares YTD; No shares bought

Within its consumables and hardgoods segments, SUMMARY OF BUSINESS  CHWY offers over 2,000 brands and 60,000 CHWY is the largest pet e-commerce company products, mostly concentrated on food and pet providing an online and mobile platform to supplies. purchase pet products and medications. CHWY CHWY boasts of high recurring revenue with provides an array of products and services nearly 68% of overall revenue being contributed including pet food and treats, pet supplies and by its subscriptions service, Autoship. This pet medications, other pet-health products, and subscription ordering program enables pet services. customers to have repeat orders automatically CHWY’s business comprises three main shipped to them at specified intervals. segments: consumables (68% of revenue), Subscribing to Autoship is a relatively seamless hardgoods (17% of revenue), and other (14% of process, involving a one-step checkout process, revenue), which primarily consists of shipping which allows a subscription to be easily changed, fees and Chewy Pharmacy segment. cancelled, or rescheduled at any time. We view Revenue by segment the Autoship subscription program as a key driver of recurring net sales and customer retention. CHWY’s core growth strategy has three main facets: first, CHWY’s main focus is on growing sales from its existing customer base and acquiring new customers; second, CHWY plans to continue differentiating itself from other retailers by expanding its healthcare segment and third, introducing private label products that fill gaps in demand. These strategies helped CHWY grow its net sales by 47.4% in Q220 and expand Source: Company Data gross margin by 190 bps.

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0.94 STOCK: CHWY | 10/03/20 FRESH LOOK

Industry Overview  RECENT DEVELOPMENTS According to the American Pet Products CHWY achieved record net sales growth and Association (APPA), spending on the overall pet customer additions in Q220 benefitting from market was $95 billion in 2019. The market is increase in online adoption due to COVID-19. further projected to grow at a CAGR of 5.1% Chewy Inc. CEO Sumit Singh during Q220 through 2024. earnings call noted that growth curves that were supposed to play out over years have been The pet industry, like many others, is in the midst compressed into quarters and even months. of a shift from in-store to online purchases. Internet shopping continues to take market share Q2 net sales were $1.7 billion, increasing 47% year from brick-and-mortar retail. Industry data over year. The key revenue drivers in the quarter provider Packaged Facts predicts that online pet were a 37.9% YOY increase in active customers product sales in the US will increase by $3.9 and a 3.2% increase in net sales per active billion dollars this year, with online sales gaining customer to $356. It ended Q2 with 16.6 million ~5% of market share year-over-year to reach 27% active customers, an increase of $4.6 million of all pet product sales in 2020. compared to Q219, breaking last quarter's customer acquisition record. We believe that the secular trend toward online shopping will continue for a significant period as penetration of online pet product spending still remains low. Another key point to note is that spending on pets is a necessity and most customers purchase frequently and at regular intervals. This makes pet industry as one of the most resilient sectors, especially in downturns. In our view, CHWY is well positioned amid a robust pet care industry, with an expanding Source: Q2 Report customer base, high customer engagement, and Autoship customer sales were $1.16 billion, up considerable Autoship adoption supporting 45.3% YOY. It accounted for 68.3% of net sales. strong recurring revenue streams.

LB•LOGIC We like companies with high recurring revenues. Further, it operates in a large and underpenetrated market which leaves significant runway for growth. While the growth has been strong, CHWY needs to show more improvement in profitability which has been lagging.

Source: Q2 Report

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0.94 STOCK: CHWY | 10/03/20 FRESH LOOK

Gross margin expanded 190 bps to 25.5% in Q220 and scale the business. It announced a new compared to 23.6% in Q219, benefiting from a fulfillment center in Archibald, Pennsylvania, favorable mix of hardgoods and strong that is scheduled to open in October 2020. Besides contributions from private label and healthcare. this, CHWY is planning to open one more Within the hard goods categories, private label fulfillment center in Kansas City in H2 2021. penetration reached 15% of net sales, providing Outlook. For the third quarter, it is expecting net gross margin benefits. sales to be between $1.70 billion and $1.72 billion, Gross Margin representing year-over-year growth of between 38% and 40%. For the full-year 2020, net sales is anticipated to be between $6.775 billion and $6.825 billion, representing year-over-year growth of between 40% and 41%. Full-year 2020 adjusted EBITDA margin is expected to be approximately breakeven plus or minus 30 bps.

LB•LOGIC CHWY is seeing continuous improvement in YOY Source: Q2 Report metrics, highlighted by strong new customer additions. We like higher CHWY reported Q2 adjusted EBITDA of $15 contribution from private label and million versus loss of $29 million in Q219. The pharmacy business, both of which increase was driven by sales momentum, gross are margin accretive. However, margin expansion, and marketing efficiencies. profitability is a concern. The gross margins are low compared to our Adjusted EBITDA liking.

 COMPANY MANAGEMENT CHWY’s management team has significant experience in leading and growing ecommerce businesses. Sumit Singh is the CEO of Chewy Inc. He has been serving in this position since 2018. Prior to that, he served as CHWY’s COO from 2017 to Source: Q2 Report 2018. From 2015 to 2017, Mr. Singh served as the Net income (excl. share-based compensation) was Worldwide Director of Amazon.com’s $5 million in Q2, versus loss of $39 million in prior consumables businesses (fresh and pantry) and, year period. from 2013 to 2015, he managed Amazon, Inc.’s North American merchant fulfillment and third- CHWY noted that it is making near-term party businesses. Prior to Amazon, Mr. Singh investments to expand its distribution capabilities

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0.94 STOCK: CHWY | 10/03/20 FRESH LOOK

served in management positions at Dell label brands which in many cases are priced Technologies Inc. cheaper than CHWY. Mario Marte is the Chief Financial Officer of While this could adversely imapct CHWY’s CHWY. He brings more than 20 years of ability to gain more market share, we believe that experience in the finance industry including the company is well equipped to compete with previously held leadership roles at a range of the larger players, as evidenced by its rapidly global companies such as Hilton Worldwide, building scale. American Airlines, Accenture. His expertise lies We expect competition in the pet products and in financial planning and analysis, treasury, services retail industry, in particular Internet- corporate strategy, risk management, and based competition, to continue to increase. commercial finance. CHWY has so far successfully differentiated itself by providing a large selection of high-quality pet food, treats and supplies, competitive pricing,  COMPETITIVE ENVIRONMENT convenience, and exceptional customer service. CHWY primarily competes in the pet retail industry with omni-channel retailers as well as online e-commerce players. Its largest LB•LOGIC The main differentiators for competitors include Petco, Walmart (WMT), platforms become customer service, convenience, product variety, and timely Target (TGT), Amazon (AMZN), and PetSmart. arrivals. We believe that CHWY is a strong The company competes primarily on the basis of player across those factors. Additionally, it continues to expand product assortment competitive pricing, brand loyalty, product and private label presence which will assortments fast and reliable delivery, and further improve customer engagement. customer service. Large players such as Amazon, Walmart have much longer experience investing in distribution and procurement. Besides this, these companies have launched their own private

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0.94 STOCK: CHWY | 10/03/20 FRESH LOOK

However, we are concerned about low margin  CONCLUSION / and lack of profitability. The gross margins are in RECOMMENDATION low to mid 20s, significantly below the usual Left CHWY shares are up 95% YTD reflecting the Brain stock selection. The company has failed to inherent resilience of pet industry and accelerated deliver profitability for the past three years, shift to online channel amid COVID-19. We are though losses have reducing every year. Even for encouraged by the favorable sales mix towards the current fiscal year, it is guiding for breakeven higher margin hardgoods and pharmacy at operating level. Its shares currently trade at segments as well as the topline guidance raise. 2.9x CYFY21E EV/Sales, which is reasonable and, in our view, reflects the low margins and profitability concerns. We assign a "YELLOW LIGHT” rating to CHWY.  Stock Chart for Chewy Inc. (CHWY)

 Performance Data 2014 2015 2016 2017 2018 2019 FREE CASH FLOW (MILLIONS USD) NA NA (15) (120) (58) (2) GROSS MARGIN (%) 12.6% 17.1% 16.6% 17.5% 20.2% 23.6% Adj. EBITDA (MILLIONS USD) (32) (32) (97) (251) (229) (252) Adj. EBITDA Margin (%) -16% -8% -11% -12% -6% -5% REVENUE (MILLIONS USD) 204 423 900 2,104 3,533 4,847 YoY Revenue Growth (%) NM 107% 113% 134% 68% 37%

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0.94 STOCK: CHWY | 10/03/20 FRESH LOOK

 Valuation Data 2014 2015 2016 2017 2018 2019 SHARE PRICE (USD) NA NA NA NA NA 29.00 SHARES OUTSTANDING (MILLIONS) NA NA NA NA NA 398.2 MARKET CAP (MILLIONS USD) NA NA NA NA NA 11,546 PRICE/SALES RATIO NA NA NA NA NA 2.4

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0.94 STOCK: CHWY | 10/03/20 FRESH LOOK

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