Former Bears Make Their Bull Case on CHWY

We are in the Moneyball Business, NOT the crystal ball business.^TM

-KCR Philosophy [1]

It is absurd to think that the general public can ever make money out of market forecasts.

-Benjamin Graham

We have long felt that the only value of stock forecasters is to make fortune-tellers look good.

–Warren Buffett

Get our insights direct to your inbox: SUBSCRIBE

Few things are more rewarding for our investment team than when a stock our sister company (L2 Asset Management) is short collapses.  And then, while off our radar, the company makes significant fundamental progress at a much cheaper price.  The reasons for our enjoyment are a mix of financial success (we made money on the short) and, perhaps more importantly, laziness.

See, the work we do on our shorts can be intense.  When they implode, we cover, and take our profits. Then, several months or years later, that same stock shows up as a candidate for inclusion in our long portfolios. This is where the lazy kicks in: our team is already well-versed in the bear thesis.

Considering the brutal collapse in price for these scenarios to happen, we typically find ourselves buying a stock we were once negative on, after the negative thesis has played out.  In such moments we often encounter a most enjoyable phenomenon:

1. When we were bearish, people often criticize us for failing to see the promise in some high-flying stock with dubious accounting.
2. Yet when we go to buy and get long the same stock after the price has plummeted and we see significant fundamental progress, well now those same people tell us we do not understand the bear thesis.
3. The irony of such moments only helps us build admittedly anecdotal further confidence.

So what does all that have to do with playing MoneyBall vs. the crystal ball business?  Our investment processes are based in data driven evidence.  Never in this research newsletter or in our asset management business, has our team created a forecast and then made an investment.  Never.

Our game of “MoneyBall” is built to systematically eviscerate our biases and preconceived notions.  Indeed, many of our most successful long-term investments over the years have been in “crappy” companies surfaced by our fundamentally data driven investment ranking methodologies.

When we started the business in 2010 our models were consistently surfacing not just tech, but semiconductor stocks within tech.   In the post dot.com era, these companies had quite predictably destroyed investors.  At the peak of the dot.com bubble, semi stocks traded at unforgiving multiples, their profit statements inflated by shady circular vendor financing schemes, and earnings quality flags everywhere.

But by 2010, the prices of these stocks had collapsed.  At the same time, there was significant rationalization in the industry, capital expenditures became focused, and the number of competitors had shrunk significantly.  Put that all together and, after a rigorous fundamental review, all we could see was a bull case.

Our preference for patiently waiting for healthy fundamentals mixed with reasonable to outright cheap prices, adheres to the inexorable math that underpins capitalism.

With that said, let us indulge in sharing one such example with you.  By the start of 2021, the online pet food and pet supplier, Chewy (CHWY) became the home of some fantastic promises.  How credulous had investors become?   Here it is in a few simple bullets:

1. At its high, CHWY stock sported a market cap of over $42 billion dollars
2. The company’s trailing twelve months sales were just over $7bn – so 6x price to sales for….
3. …a loss making business diluting owners via stock-based comp to offset the cash losses

To us the short thesis was simply “the bull thesis, and a great deal more, has already been baked in.”  In the chart below we show the period our hedge fund strategies held short positions in CHWY.   The line is the stock price of CHWY.  The area shaded in red is where our sister company’s hedge funds held a short position (we make money when the stock falls).   You can see there’s a stretch there with no color.  That’s because CHWY wasn’t good and cheap enough to buy but was also no longer a “safe” stock to be short.

Looking at the green you can see where we initiated our long position.  Did we manage to get out of the short and into it as a long at the dead low?  No.    The stock price floated higher on us but the fundamentals improved even faster.  As this note will explain: CHWY is a remarkable debt-free company with robust cash flows, top-line growing 2-3x faster than GDP, a credible path to doubling margins and secular tailwinds that remove a great deal of the cyclical risks we see in other web-based and AI intensive businesses.

Founded in 2011, Chewy, Inc. (CHWY) is an e-commerce platform that sells 130,000 types of pet products, supplies, and prescriptions, including its most important sector, pet food and treats.  CHWY operates no physical pet product-related retail stores.  CHWY has an approximate 40% share of the online pet supplies market.  Its chief competitors include Petco Health and Wellness Company, Inc.; Amazon.com and Walmart.com, which have huge pet sections on their e-commerce platforms; and a variety of smaller specialized pet retailers.

Why We are Bullish on CHWY:

• Chewy, Inc. (CHWY) is a free cash-flowing, debt-free company with a dominant and growing market share in an industry that is not only gaining customers each year, but also one in which each customer increases his/her spending annually.

• The pet care industry has demonstrated resilience across economic cycles because of the essential, repeat nature of a pet’s needs and the company further benefits from:

• • Fantastic demographic tailwinds
  • Pet owners spending on their pets growing 3x faster than growth in pet ownership
  • As a result, CHWY is growing at 2x the rate of the broad pet care industry
  • 84% of CHWY’s revenues come from recurring subscription business
  • One KCR team member notes: “my dogs go crazy when the CHWY box comes!”

• CHWY has a world-class fulfillment network that is essentially fully built out.  It currently operates at least six automated fulfillment centers in Tennessee, Nevada, Missouri, and Pennsylvania.

• CHWY can cost efficiently ship products to more than 80% of the U.S. population overnight and nearly 100% in two days.  All this implies that as CHWY continues to grow, more of its revenue will fall to its bottom line as the business scales and the incremental cost of filling customer orders declines.

• CHWY is a rare company that is easy to understand with a dominant industry position, growing sales ~10% a year, a durable competitive moat, significant operating leverage, and a 5% FCF yield.
• Ignoring the near certainty of significant sales growth, each 100 basis point jump in its EBITDA margin would equate to roughly a $6 jump in CHWY’s stock price and it seems plausible that margins double from ~5% today to ~10%.  Fortunately, we do not need this to happen for the stock to work, in our view.

• When we aggregate these data points, a reasonable intermediate price target for CHWY stock is around $40.  At that price, the stock would still trade at a significant discount to the S&P500 which currently has a FCF yield of just over 1%.

Nobody at KCR can tell you what AI models we will be using in 2-3 years, much less what we will be using them for.  But we can tell you, the dogs will get fed, the prices at CHWY are terrific, and the fulfillment is better than Amazon (in our personal experience).  

Ask yourself or your clients:

“Would you rather own a $4.6 trillion dollar semiconductor stock like NVDA with a 1.5% FCF yield despite the highest margins in history with competitors like AMD and others breathing down their neck, or would you rather own a low-cost, highly-efficient, pet-food company, with 84% of sales coming from recurring subscriptions and tremendous secular tailwinds?”

What is the Bear Case?  If the impressive sales and margin growth that CHWY has demonstrated in FY 2024 and especially in FY 2025 were to reverse, the stock could underperform.  However, given the consistent growth in pet ownership in the U.S. and customers’ increasing desire to purchase pet products online versus at physical pet stores, it is difficult to envision such a negative scenario unless the economy were to enter a deep recession.