By Trevor Muchedzi, CFA “
The era of pet parenting
Millennials are putting off marriage and starting families relatively later in life compared to Generation X but there is one commitment they are ready to make early on: owning a pet! For centuries, humans have had a special relationship with pets but over the last decade the way we view, think and care about our pets has dramatically changed. No longer are we pet owners; we are now pet parents!
Below are some interesting anecdotes with regards the U.S. pet market:
- 68% of American households have at least one pet: we are talking about 84.6 million families. In fact, there are more households with pets than with children in the U.S right now;
- Of these, 85% view them as “inseparable members of the family” and therefore deserve to be coddled and pampered just like little children;
- 44% of American millennials consider their pets as “starter children”; and
- Spending on pet food and supplies is one of the most resilient categories during economic downturns because they are viewed as a necessity. For example, during the recession of 2008 to 2010, overall consumer spending in the United States declined while pet spending increased by 12%
Welcome to the era of pet humanization
Whilst pets are great companions, they are also big business. Americans spent over $70 billion on their pets in 2018, up 68% from 10 years ago. Although pet food is still the dominant segment, much of the growth is coming from increased spending on non-food items like medication and non-medical products and services e.g. training, pet beds, grooming services and indoor dog swimming pools (yes, that’s a thing!).
On a macro view, there are two main factors that are driving the strong growth with the pet industry:
Driver #1: An aging population
Baby boomers, the largest generation in history, are entering a new phase of life as empty nesters and retirees. With that, there is a rising number of empty rooms in their homes and what better way to fill it up than with a pet. Today, more than 55% of retirees have at least one pet
Driver #2: Pet humanization
The evolution in which pets are viewed as family members has given rise to a new phenomenon called “pet humanization”. This means that people now consider their cats and dogs as inseparable members of the family and indistinguishable to children, and they are therefore willing to spend increasingly larger dollar amounts on higher-quality goods and services for those family members. The pet humanization trend manifests itself in multiple ways:
- Premium food: There is an increased focus on the impact of diet on pet health, leading to higher spending per pet on premium, healthier pet foods that are generally more expensive. According to Packaged Facts, ~75% of pet owners are willing to pay more for healthier pet food products.
- Healthcare: Spending on pet healthcare, including pet drug prescriptions and pet health insurance, has increased dramatically and a growing number of people now carry health insurance for their pets;
- Services: Annual spending on non-medical pet services e.g. grooming, boarding, sitting, walking, and training services is growing at 5.7% year-on-year (that is twice the average GDP growth).
- In-door living: 59% of dog owners in America keep their dogs exclusively inside the house except when they take them for walks. This contrasts to only 4% who keep them exclusively outside
- Other consumables: Last year, ~3.4 million households spent money on non-food items like pets beds, clothing and treats for the first time ever
Understanding the dynamics of the pet retail business
Pet food, medication and related services is a very commoditized and highly competitive business with little in the way of product differentiation, well at least historically. In such a market, a retailer who can deliver the cheapest product at an acceptable level of customer service normally wins. Given that people generally consider shopping for pet items as a chore and that once they have decided what their dog/cat eats they hardly switch, companies are looking for ways to make their entire process to seamless and easy.
For years, large brick & mortar big box retailers had dominated the pet food and suppliers retail landscape. However, given that pet food is generally bulky, it meant people had to physically carry a 15kg bag around: imagine an old retiree having to do that. In addition, most people living in developed countries stay within dense cities and use public transport to commute to and from work. Unless one stayed very close to the shopping centre, he/she had to carry a large bag of dog food on the subway and public bus on a periodic basis.
Therefore, with the evolution of e-commerce, a growing number of people have simply opted for buying their pet supplies online and have them delivered to their doorstep. The recurring nature of the spend and the automated process make online pet food shopping easier for customers. Lastly, given also that pet food generally has long expiry periods, it renders itself an ideal product for bulk buying which can yield cost savings on behalf of the customer.
The rise of Chewy.com: Cashing in on the booming demand for spoiled cats and dogs
Sensing the opportunity, Ryan Cohen and Michael Day launched Chewy in 2011 as a pure play pet e-commerce retailer in the United States. Knowing how commoditized the business is, the founders pivoted their company to focus relentlessly on providing superior customer service and automating the entire process of buying and take care of your pet. As a consequence, the company grew rapidly with revenue rising from $26 million in 2012 to $3.5 billion by 2018. Today, Chewy is the largest online pet food and supplies retailer in the U.S. with a 41.6% online market share.
Figure 2: Chewy.com revenue growth since launch
Pet food purchases are highly recurring in nature since pet foods are a necessary purchase for owners. Therefore, to automate the process and make ordering pet food easy, the company launched a AutoShip subscription based program that enables customers to have repeat orders automatically shipped to their houses on specific dates. Customers have clearly found this service so valuable that AutoShip sales now constitute 66% of Chewy’s annual revenue and that the company continuously achieves a 120% dollar retention rate (the best in breed aim for 110% retention rates)
But looking at the financials tell a different story
The table below provides a depiction of the company’s financials for the past three years
|Variable ($’ million)||FY 2016||FY 2017||FY 2018||Commentary|
|Revenue growth||113%||134%||68%||Growth will continue slowing down as the company grows bigger|
|Gross profit margin||16.7%||17.5%||20.2%||Improving margins reflects Chewy’s increasing bargaining power|
|Sales & Marketing||108||254||393|
|% of revenue||12%||12%||11%||High marketing spend is a reflection of “land grab” approach|
|Fulfilment & Logistic costs (“FC”)||104||259||404|
|% of revenue||11.5%||12.3%||11.4%||See commentary below on FC|
|Other ops costs||46||193||186|
|% of revenue||5.1%||9.2%||5.2%|
|Operating profit margin||-11.9%||-16.1%||-7.5%||See commentary below on operating margins|
|# of active customers||3.0 million||6.8 million||10.6 million|
|AutoShip as a % of total sales||62.8%||61.5%||65.7%||AutoShip Customers are the most lucrative & are cheaper to serve|
Despite very strong revenue growth, Chewy is still loss making, well at least on surface. But to understand the investment case for a fast-growing company like Chewy, investors have to look beyond the P&L to the company’s unit economics at maturity and unpack the intricate details of a high growth early stage business in a “land grab” phase.
Land grab phase – Expropriation without compensation
Online start-up companies often follow a “land-grab” business model approach in which they initially prioritise customer acquisition and revenue growth over profitability. Depending on the business model, the land grab dynamics come in different forms such as aggressively investing in developing fulfilment centres and logistics network to expand reach, or providing subsidies or free shipping to stimulate demand. All this is meant to attract traffic and get more customers hooked to their platform.
For e-commerce companies, fulfillment and logistics costs per order tend to rise quickly as the company expands aggressively and then decline as the fulfilment centres mature and the land grab phase is over. When that happens, the company’s operating costs per unit order will be optimized as larger sales are spread over a fixed cost base and operating profit margins starts growing faster than revenue growth.
Evolution of growth profile of comparable online companies
Secondly, as the land grab phase dissipates, companies also tend to scale back on their marketing spend in relation to revenue. Therefore, all in all, operating expenses per order will go down and that entire cost saving will flow directly to the bottom line.
As such, the table below provides a picture of how Chewy’s unit economics will look at maturity based on how other comparable e-commerce companies have done.
Unit economics at maturity
|Average Revenue Per Customer||$334|
|x GP margin (comparable e-commerce players)||25% – 30%|
|GP per customer||$84- $100|
|Fulfillment costs||8% – 10%|
|Other operating costs||10% – 11%|
|Operating profit per customer||$23 – $33|
|Operating profit margin||7% – 9%|
Secular tailwinds supporting the investment case for Chewy
Making the flywheel spin faster
As highlighted above, Chewy is currently investing heavily to grow its click-to-door fulfillment network and customer service centres across the country. Today, the company operates seven fulfillment and three customer centres which enable it to ship pet food and supplies to approximately 80% of the U.S. population overnight and almost 100% within two days!
Such massive levels investments will only lead to higher customer satisfaction which will cement Chewy’s position as the leading e-commerce platform for pet food and supplies. This will mean high sales retention which will consequently drive even more revenue growth and higher profitability in future. This is how you get your flywheel to spin even more faster:
Chewy’s flywheel: How to keep customers coming back
The pie keeps getting bigger: Consumers are shifting from offline to online
The pet industry, like many others in the United States, is in the midst of a shift from in-store to online purchases, with e-commerce representing a 12% share of the food and supplies market segment, up from 4% in 2015, and projected to grow to approximately 21% by 2022.
These secular trends toward online shopping for pet food and supplies will probably continue for a significant period and is expected to grow at about 17% CAGR over the next five years before slowing down. The table below provides a high-level overview of how the revenue pool will grow to reach ~$20 billion in 2023 up from US$8.6 billion in 2018
|U.S. Pet care industry TAM||$72 billion|
|x % of online sales||12%|
|= Online sales TAM||$8.6 billion|
|x Estimate growth rate on online sales||17%|
|x Number of years||5|
|Total online pet care sales in 5 years||$19 billion|
|U.S. Pet care industry TAM||$72 billion|
|x Overall market growth||4.2%|
|x Number of years||5|
|Total pet care sales (off and online) 5 years||$87 billion|
|Total online pet care sales in 5 years||$19 billion|
|/ Total pet care sales (off and online) in 5 years||$87 billion|
|Estimated online market share in 5 years||22%|
Valuation, valuation, valuation!!!
Rumour has it that Chewy will seek a valuation of $4.5 billion when it goes public (we will know better once the company has updated its S-1 filing over the next few weeks). Fast growing but loss-making companies are generally difficult to value because if the thesis plays out as described above, then Chewy will gain even more market share and become more valuable year after year.
One way to value a high growing business like Chewy is to assess its valuation at maturity, when the business in now growing in line with the industry. At that point, we can use multiples of other listed e-commerce companies to estimate the value of Chewy
To do that, I have formulated the following key assumptions:
- The total pet care industry (both off and online) will grow at 4% p.a.
- Total online market share at maturity: 50% (up from 12% today)
- Chewy’s online market share: 30% – 60% (base case scenario is 50% market share)
- Operating margins: 9%
- Terminal Price/EBITDA multiple: 12.5x
- Time to maturity: 10 years
Therefore, in our base case scenario, we expected the company to have an Enterprise Value of $29 billion, which represents a 21% y-o-y CAGR over the next 10 years. I think this is fairly conservative given we assuming a 50% total online market penetration. I see a future when more than 80% of retail sales will be done online.
How far the phenomenon of pet humanization goes is anyone’s guess. But one thing for sure is that the relationship between people and their pets has evolved and will continue to do so. Today families are taking their pets for grooming and holding formal funerals when they pass on. With all that emotional connection, there is definitely money to be made.
For years, Chewy has refined the art of deepening this bond between people and their loved pets. Today the company employs a lot of people as card writers whose only job is to drive the connection between pet parents and their pets to another level. The picture below is an example of a card was sent by Chewy to one of its customers whose dog has died. Talk about customer service!!!
If there is a business that I love to invest in, it’s
one with loyal and emotionally connected customers. Who is better than Chewy at
getting their customers to spend even more money buying their dogs fancy
toothpaste: Nylabone Advanced Oral Care – beef flavoured!!
 American Pet Product Associations (https://www.americanpetproducts.org/)
 Source: Packaged Facts 2018
 Largely informed by other e-commerce companies within the retail space