Autoship and Rx: The Backbone for Hitting Chewy's Margin Target

Online pet retailer and pharmacy company Chewy (NYSE: CHWY) is down roughly 17% since the announcement of CTO Satish Mehta's retirement last month. Another leadership change, following the CFO's exit last year, is the last thing investors wanted to hear. The stock is now down by more than 30% since Chewy reported second-quarter results in September.

Leadership turnover like this should raise an eyebrow, especially at a time when investors are looking for signs of stability. The primary anchor remains Autoship, which provides a durable revenue stream, as 84% of net sales flow through the subscription service.

Autoship presents the bears with a predictable problem

Chewy's membership program allows pet parents to schedule shipments of food, medication, and supplies. These orders provide management with high visibility into demand, shielding the business from the unpredictability of retail sales. Revenue flowing through this pipeline rose 13.5% in the third quarter, while total sales growth of 8.5% outpaced the broader industry.

The business continues to grow faster than the market, expanding its active customer count and net sales per active customer by 5% each. Beyond the sales volume, the repeat-purchase model improves the bottom line because the revenue carries no additional acquisition costs.

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The service also provides Chewy with a committed base of customers to convert to higher-margin health services. Chewy's pet pharmacy is the leader in the U.S. by prescription volume. The recurring nature of medication refills aligns well with the automated delivery model.

Scaling this higher-margin business is a priority that could lift overall profitability over time. In Q3, we saw the impact as gross and adjusted EBITDA margins expanded by 50 and 100 basis points, respectively.

Funding growth through subscription cash

The sticky revenue doesn't remove all risks for the stock. For now, it's still a low-margin e-commerce retailer in a slow-growth industry. That won't change overnight, but it does provide reliable cash flow for leadership to reinvest in growth initiatives. Management continues to invest in its 2023 rollout in Canada and in its 2024 entry into pet care through its Chewy Vet Care clinics.

The company opened two new locations during the third quarter, bringing the total to 14. While these physical sites carry higher operating expenses due to specialized staffing, a $675 million cash pile and zero debt provide plenty of capital to test this new opportunity.

The loss of the CFO and the CTO's retirement in short order raises concerns and complicates the investment story. On the other hand, Autoship will continue to roll along, pumping out FCF, and its pharmacy business is another valuable part of the business. This, combined with Chewy's generous net cash position, provides a reasonable margin of safety for a stock trading for just 18 times next year's earnings estimates.

Bryan White has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Chewy. The Motley Fool has a disclosure policy.