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In his most recent letter to investors, David Einhorn of Greenlight Capital wrote that today's market bears resemblance to the tech bubble of 2000. He then compared Chewy, the company I founded in 2011 and ran as CEO until last year, to the ill-fated Pets.com.
I am no stranger to the Pets.com comparison. I heard it when I first started the business and again from nearly every venture capital firm I spoke with on Sandhill Road in Silicon Valley. After building Chewy for 8 years with a talented and dedicated management team, upon reading Einhorn's comments I felt compelled to defend the business we built. The comparison to Pets.com is not only off-base but it does a great disservice to all the hard work the incredible people at Chewy have done over the years to build the world's largest online pet retailer with more than 11 million loyal customers.
Since crashing and burning less than two years after its formation in 1999, Pets.com has served as the symbol for the capital markets' excesses of the era. The company was fast growing, structurally unprofitable, and paid for sales by overspending on advertising.
Simply comparing the relative market capitalization and absolute cash burn does little without understanding the scale advantage, unit economics, and the inherent attractiveness of Chewy's business model over its predecessor.
Mr. Einhorn's primary complaint seems to be that Chewy is valued at 30 times what Pets.com was at its peak, claiming this as a reason for skepticism. He makes the point that in its heyday, Pets.com boasted a market capitalization of ~$400 million, which is dwarfed by Chewy's more than $13 billion valuation, however these are useless metrics without context.
While Chewy's current market cap is certainly more than 30 times that of Pets.com it also does 583 times more revenue, has positive gross margins, and boasts customer retention rates that outpace most software companies. While on a superficial level it is easy to draw parallels between the two highest profile online pet retailers, the reality is that Chewy is a fundamentally bigger, better and different business today than Pets.com ever was.
Chewy today is orders of magnitude larger than Pets.com, which allows it to leverage the high initial costs of shipping and fulfilling orders. Most people would find it futile to compare a company that did $6 million in revenue (like Pets.com) to one that eclipsed $3.5 billion last year. The importance of achieving scale in e-commerce cannot be overstated and is the first fundamental flaw in the comparison. Jeff Bezos explained this in Amazon's 2000 letter to shareholders:
Online selling (relative to traditional retailing) is a scale business characterized by high fixed costs and relatively low variable costs. This makes it difficult to be a medium-sized e-commerce company. With a long enough financing runway, Pets.com and living.com may have been able to acquire enough customers to achieve the needed scale. But when the capital markets closed the door on financing Internet companies, these companies simply had no choice but to close their doors.
In order to make the necessary investments in its fixed costs – i.e. shipping and fulfillment infrastructure – an e-commerce company must grow fast enough that it can spread these high initial costs over a large enough revenue base. Unfortunately for Pets.com, the market wasn't large enough to be viable at the time. In 2000 only 22% of Americans had ever made a purchase online and only 7% of Americans used the internet as a part of their routine product searches. The idea of buying anything online, let alone pet food, was a foreign concept to most consumers. This led to inefficient customer acquisition spending like $20 million on Super Bowl ads and a talking sock puppet, which never was able to move the needle fast enough for Pets.com to scale.
Internet companies today are doing billions in sales compared to millions of page visits 20 years ago. The rise of performance and direct marketing has reduced the friction in customer acquisition and allowed companies like Chewy to acquire customers more precisely and more cheaply than ever before.
The former Pets.com CEO, Julie Wainwright, explained the difference between then and now concisely in 2011:
Here is what the world looked like in 2000....there were no plug and play solutions for ecommerce/warehouse management and customer service that could scale...which means that we had to employ 40+ engineers. Cloud computing did not exist, which means that we had to have a server farm and several IT people to insure that the site did not go down. There were less than 250 Million worldwide Internet consumers in 2000- now there are 5 Billion. Amazon has reported a loss of nearly $900M in 1999...because guess what, ecommerce is a business of scale.
Since 2014, Chewy has grown from $200 million in sales to over $3.5 billion last year, now has over 11 million customers and purchases by existing customers represent 90% of revenue. The company has 7 distribution centers nationwide and can ship to 80% of the U.S. population overnight and almost 100% in two days. There's no question that the fundamental barriers to scale exhibited in 2000 do not exist today, and that Chewy has been able to leverage its scale successfully over its history.
While Mr. Einhorn is correct in saying that Chewy has not been net profitable under GAAP standards, this obscures the core profitability of Chewy's business. Between 2014 and 2018, the company burned only $134 million in free cash flow while growing revenue from $200 million to over $3.5 billion and spending approximately $750 million on marketing. Since inception, Chewy has had a positive gross margin and in the last three years the margin has expanded from 16.7% to over 20% in 2018.
While Mr. Einhorn may view marketing spending as throwing good money after bad, that is a misunderstanding of the lifetime value of a Chewy customer. By spending to acquire new customers, the company is deliberately depressing profitability of the existing customer base.
Given the underlying profitability and stickiness of existing customers, there was never a doubt that the marketing spend was yielding incremental returns above our hurdle rate. While the governor of growth has always been free cash flow, the lifetime value of customer acquisition was still above short-term profitability. Chewy could have been profitable years ago had we cut off the marketing spending, but it was a strategic decision to acquire and retain customers in order to maximize the long-term value of the business.
In Mr. Einhorn's letter to his investors, he paraphrased Benjamin Graham in saying "Over the short-term the market is a voting machine and over the long-term it is a weighing machine." I fundamentally agree with this quote, but not for the reasons it appears that Mr. Einhorn does. Just as the daily stock price is no indication of the quality of a business, the quarterly profitability of a company like Chewy has no bearing on the terminal value. We consistently chose to defer profitability in the short term in order to maximize shareholder value over the long term.
Value investing and entrepreneurialism are very much the same in the sense that they require contrarian decisions without immediate payback and run the risk of being misunderstood by the market for long periods of time. We've seen this playbook pay off for companies like Amazon and Netflix, but their success doesn't make it any less nerve racking – especially when you have thousands of employees that depend on you for their job. Without conviction in the underlying economics of the business, I would have found it very hard to sleep at night if I thought our strategy wasn't in the best interest of those employees, our millions of customers, or Chewy's shareholders.
From day one, we chose to be a customer-obsessed business and replicate the experience of shopping in the neighborhood pet store. That meant focusing on bringing a human element to e-commerce and doing it at scale. Small touches like handwritten holiday cards and personalized pet portraits were ways we felt we could connect with customers and build loyalty over time.
While lots of companies talk about their flywheel, I truly believe that Chewy's relationship with customers is the secret sauce. This is no more evident than in the fact that Chewy customers spend more with the company as time goes on – implying not only a level of trust but service and reliability. The net sales per active customer increased from $223 per year in 2012 to more than $334 in 2018.
All this to say that comparing Chewy to Pets.com is not only fundamentally incorrect but requires a deliberate misunderstanding of the evolution of e-commerce since the days of 1999-2001, as well as the importance of investing in the long-term viability of the business. While a quick glance may tell you that this business is no different than any other online pet retailer, ask any of Chewy's customers and you'll get a very different answer.
Even though I left Chewy last year, I'm extremely proud of the company and team we built. I urge investors to dig deeper into understanding the Chewy business and next time, let's compare apples to apples. Times have changed.
Ryan Cohen is the founder and former CEO of e-commerce company Chewy, which went public in June.