Petco Health and Wellness (WOOF) is down nearly 17% in mid-afternoon trading Wednesday. The company reported Q1 2023 earnings this morning before the opening. Investors did not like the gross margin erosion in the quarter. As a result, volume is 6x its 30-day average.
At the same time, Chewy (CHWY) lost more than 3% of its value on the day, even though it reports its earnings on May 31 after the markets close. As a result, its volume on the day is slightly higher than its 30-day average.
If you're considering buying either of these stocks, which I don’t recommend, I will point out the negatives of each of these businesses. By the end, you'll know which of the two is the worse stock to buy.
Petco’s Eroding Margins
As I said in the intro, Petco’s gross margins in the quarter fell by 240 basis points to 38.8% from 41.2% a year earlier. So, Its gross profit was the same year-over-year at $604.5 million on nearly $80 million in additional Q1 2023 revenue.
Combine this margin erosion with a 3% increase in operating expenses, and you won’t be moving the profitability needle. On a GAAP basis, it lost $1.9 million, down from a $24.7 million profit in Q1 2022. Feeling generous, the non-GAAP net income in the quarter was $14.9 million, 59% less than last year.
You’ll notice that the company’s net debt at the end of the first quarter was $2.9 billion, down slightly from the end of January but still 115% higher than its market cap. In addition, its interest payments in the quarter were $37.2 million, 89% higher than Q1 2022, effectively taking an operating profit and reducing it to a loss.
With interest rates likely to remain high for the remainder of the year, Petco’s business faces considerable financial stress.
However, it did reaffirm its guidance for 2023, which includes revenue of at least $6.15 billion and $520 million adjusted EBITDA (earnings before interest, taxes, depreciation and amortization). Both the top and bottom lines should be higher over 2022.
Furthermore, you shouldn't ignore that it delivered same-store sales growth of 5.1% in the quarter, its 18th consecutive quarterly increase. If it didn’t have so much debt, you could write off this quarter as no big deal.
It will be interesting to see what, if anything, analysts do after today’s results. Of the 13 covering its stock, according to Barchart.com data, rate it a Moderate Buy (3.92 out of 5) with a mean target price of $11.81, 42% higher than where it’s currently trading.
I’d be shocked if it didn't get a downgrade or three by the end of the week.
Chewy’s Business Isn’t Much Better
As I said, Chewy reports its Q1 2023 results a week from today. Of the 10 analysts with an earnings estimate on CHWY, the average is a loss of one cent a share, down from a 4-cent profit a year earlier. For all of 2023, analysts expect it to make a small 2-cent profit, down from $0.15 in 2022.
The good news is that Chewy’s delivered big earnings surprises in the past four quarters. In Q4 2022, analysts expect a 24-cent loss. Instead, it came in at a 4-cent profit, for a 117% earnings surprise.
Of the two, CHWY gets a slightly higher rating from analysts. Although it also receives a Moderate Buy, its score out of 5 from the 23 analysts covering it is 4.17, 25 points higher than Petco, with a mean target price of $44.61, 41% higher than its current share price.
So, there isn’t much difference between the two from an analyst's perspective.
Regarding the balance sheet, Chewy’s is much more robust, with net cash of $178.0 million. Moreover, in 2022, its net interest expense was just $9.3 million, about one-quarter of Petco’s for Q1 2023.
From this perspective, it’s easy to see why Chewy’s Altman Z-Score -- a calculation that predicts the likelihood of bankruptcy within 24 months -- is 6.39 (anything above 3.0 is considered in the Safe Zone) while Petco’s is 1.38. Conversely, anything below 1.81 is considered in the Distress Zone, signaling bankruptcy could be imminent.
If you own Chewy stock, you shouldn’t kick back and think you’ve got it made. Its adjusted EBITDA margin in 2022 was just 3.0% on $10.1 billion in revenue. By comparison, Kroger’s (KR) 2022 adjusted EBITDA margin was 23.2%, or nearly 8x Chewy’s.
Since Chewy went public in 2019, its lost money on an EBITDA basis every year except 2022. Given Petco’s margin erosion in the first quarter, it’s more than possible that Chewy’s Q1 2023 loss will be higher than the analyst estimate of -$0.01.
Chewy stock is down nearly 11% YTD and 10% over the past five years. Should it miss instead of beating the estimate, it’s likely to decline by double digits on the news.
Given the current economic uncertainty, I think today’s news from Petco is a warning to anyone considering buying either stock. However, while Petco’s financial condition is much worse, making it the worse buy here, I would say that the difference between the two isn’t nearly as significant as you might think.
If you want to buy a stock, buy Kroger. It’s far more profitable.
On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
