Chewy (CHWY), the online pet supplies merchant that has been an investor favorite all year long, has been a big winner since its IPO almost a year ago now at just $22 per share. And Chewy has strong fundamentals to show for it – instead of seeing growth slow down in the wake of a coronavirus that has damaged most consumer-facing companies, the global pandemic was actually a tailwind to Chewy’s business, with growth accelerating in its most recent quarter.

Yet despite strong Q1 results, shares of Chewy slipped post-earnings, reflecting the reality that shares are already priced for perfection.

Data by YCharts

Investors’ enthusiasm in Chewy’s fundamentals and its growth trajectory is valid. Chewy has a host of factors going for it, including the fact that the pet category is still under penetrated by e-commerce. Especially after the coronavirus hit and shuttered many neighborhood brick-and-mortar pet stores, Chewy has been able to absorb a lot of the demand and shift more customers toward its site that may never have purchased pet food online before. After all, pets still have to eat – pandemic or not.

Then there’s the autoship business that Chewy is heavily promoting. E-commerce companies like Amazon (AMZN) have found huge success in creating recurring orders (and Amazon has even offered small discounts to incentivize repeat shipments), and Chewy has adopted that playbook in allowing customers to order recurring quantities of supplies. With autoship making up a growing portion (more than two-thirds) of Chewy’s business, it may eventually be fair to start considering Chewy almost like a subscription company.

But growth aside, Chewy still carries fairly low gross margins – and at the same time, the stock’s current price puts the company at a market cap north of roughly $20 billion for a company that hasn’t yet turned out a dime in profits. Profitability improvements are coming very slowly – so even if Chewy turns out astronomical growth rates, it’s unclear when we’ll see it generate meaningful enough profits for us to justify Chewy’s valuation on standard metrics like P/E or EV/EBITDA.

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The bottom line on Chewy: great growth story, but stay on the sidelines until the stock gives back some of its massive year-to-date gains (at the time of writing, Chewy is up an impressive ~68% year-to-date while the S&P 500 is slightly below flat).

Q1 download: growth outperforms, but we’d really like to see more movement in profits

I’d sum up Chewy’s first-quarter results as follows: the coronavirus drove a huge surge in demand, but the impact that had on generating profit growth was less than impressive.

Chewy’s revenue grew 46% y/y in the quarter to an impressive $1.62 billion, smashing Wall Street’s expectations of $1.53 billion (+38% y/y). This also came in well ahead of Chewy’s own original forecast for the quarter of 35-37% y/y growth, as well as accelerating eleven points versus Q4’s 35% y/y growth rate.

Figure 1. Chewy revenue trendsSource: Chewy 1Q20 earnings release

Sumit Singh, Chewy’s CEO, commented on the tailwinds from the coronavirus as follows on the Q1 earnings call:

First, we added a record 1.6 million net active customers in the first quarter, which was more than double our average quarterly pace of net active customer adds in 2019. Second, and equally as important, the behavior shown so far by these new customers is promising. Initial orders were up 11%, larger in value than our pre-COVID-19 customers.

In the first four weeks since their initial purchase, a higher percentage of our new customers returned to make a second purchase, and the average value of those repeat orders was as much as 5% higher than the pre-COVID customers. Finally, we analyzed their Autoship sign-up and cancellation risk. And on a net basis, they were within historical ranges. These insights bode well as a sign of future customer engagement.

And although we cannot predict the future, currently, we’re expecting these customers to become long-term Chewy customers. We also observed encouraging signs from our existing customers. In the quarter, we saw nearly double the number of customers coming back into active status versus previous quarters. This means more customers who had not made a purchase with us in the previous year returned to an active status, providing us an opportunity to reengage them.”

Perhaps even more important than this quarter’s raw revenue numbers is the fact that Chewy reported higher repeat orders and is expecting more long-term conversion from customers who signed up during the coronavirus. As in, the Q1 sales bump wasn’t just a one-time pandemic fluke, but demand upside that can be reliably sustained.

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And as noted in the comments above, Autoship also had a big quarter. Chewy’s Q1 autoship sales were $1.10 billion, representing a staggering 68% of revenues that is theoretically recurring – and supporting the thesis that all the new customers Chewy signed on in Q1 will continue to provide repeat value for the company.

Unfortunately, however, Chewy’s massive revenue growth didn’t provide a huge corresponding boost in profit margins. Chewy’s gross margin did expand 50bps in Q1, but we’d have hoped for more – although on the bright side, Chewy called out 120bps of gross margin headwind from freight and logistics investments that will likely normalize over the coming quarters.

Figure 2. Chewy gross marginsSource: Chewy 1Q20 earnings release

Similarly on adjusted EBITDA, Chewy marginally boosted EBITDA from slightly-negative in 1Q19 to barely above breakeven this quarter, representing a modest 160bps improvement in adjusted EBITDA margins.

Figure 3. Chewy adjusted EBITDA trendsSource: Chewy 1Q20 earnings release

Chewy’s large stock comp (excluded from adjusted EBITDA), however, masks some of the company’s growing losses from a GAAP perspective. Even though adjusted EBITDA turned barely positive, GAAP net losses widened from -$30.3 million in 1Q19 (a -2.8% net margin) to -$47.5 million (slightly worse at -2.9% net margin) in the current Q1. Stock comp itself rose dramatically, from -$7.2 million in 1Q19 to -$42.2 million in the current quarter. This isn’t “free” – instead of paying employees in cash, Chewy is instead paying via dilution to its shares, which is a cost ultimately borne by investors.

This underscores my original point: Chewy is a ~$20 billion market cap company that is generating substantial growth, but EBITDA/free cash flows are still hovering barely around breakeven while net losses are still growing. I think that for Chewy to rise substantially higher, it needs to show some improvement on the profit track and prove that it can convert some of its pandemic-boosted growth into real profits.

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Key takeaways

One other point that we should make against Chewy is that its moat isn’t necessarily wide. Amazon (AMZN) already sells pet supplies, and there’s nothing stopping the e-commerce giant or other companies from focusing more on pets and infringing on Chewy’s space. Brick-and-mortar pet stores like Petco (the biggest competitor to PetSmart, the company Chewy was spun out of) could also choose to invest more into their e-commerce operations.

With all this in mind, plus the fact that Chewy has yet to generate any meaningful profits, we have to question the company’s giant ~$20 billion market cap. I’d continue to stay on the sidelines here until Chewy proves that it can become a bottom-line story as well.

I’m launching The Daily Tech Download, a Seeking Alpha Marketplace service, on June 22. Subscribers will get access to a daily comps sheet tracking valuation changes in the tech sector and access to exclusive ideas. Stay tuned and contact me for more information.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.