The Perfect Pet Stock

Michael Shulman

Looking for the perfect pet stock to trade?

If you own pets, you’re familiar with Chewy (NYSE: CHWY), the online retailer of pet food and other supplies.

And CHWY is one of my favorite income stocks to trade for 2020.

My cockapoo, Sumo, is quite old and lives to eat and sleep. He gets two cans of fairly expensive food every day, which averages out to around 60 cans a month. Chewy’s auto-ship service makes my life much easier.

This convenience, along with Chewy’s low prices and excellent customer service, have made it a hit among pet owners. The number of active customers and revenue are growing at double-digit clips, and the stock offers a pure play on U.S. growth.

Great Income Stocks

Of course, I am not a growth investor in the traditional sense. That is to say, I don’t buy and hold stocks hoping they will go higher. There’s nothing wrong with that, per se, especially in a year like we saw in 2019. But I’m focused on generating income by selling options.

That said, fundamentals have and always will guide my trading. And that’s why I am drawn to a pet stock like CHWY.

If you are not familiar with how I select the best income stocks to trade, my research process flows like this:

  • A tradable trend
  • The best company or companies in that trend based on growth, profitability and a competitive advantage
  • Stocks that are undervalued (based on revenue and profit growth) compared to their sector and/or the overall market
  • Charts that offer short- and/or long-term trading ranges
  • Option chains with weekly expirations and enough liquidity to facilitate reasonable bid-ask spreads
  • Premiums that are large enough to provide a return of at least 0.5% a week

Let’s run through each so you can see why I’m so excited to trade Chewy.

The Trend

 Americans love their pets.

In the late 1980s, 56% of U.S. households reported owning a pet, according to a survey conducted by the American Pet Products Association (APPA). That number now stands at 67%, or around 85 million families.

And, as you might have noticed, they seem to love them more than ever.

People have practically elevated their pets to the level of their human offspring — feeding them grain-free, organic food, buying them plush bedding and all-natural toys, and dressing them in Halloween costumes. (And whether you love or loathe the cultural shift of humanizing pets, no one is abandoning their children — human or the fur variety — when a recession hits.)

Given this trend, it’s hardly surprising that research shows pet market sales have been steadily increasing. Americans spent an estimated $75.38 billion on their pets last year, according to research complied by APPA. That’s up nearly 4% from 2018 and more than double spending levels in 2005.

Millennials now represent the largest segment of pet owners, and they don’t seem to be sparing much expense when it comes to their furry friends. A 2018 TD Ameritrade survey showed that dog owners spend an average of $1,285 a year on their pet, while cat owners spend an average of $915 a year.

And if there’s one thing we know about millennials (and plenty of non-millennials as well) it’s that they love the convenience of online shopping.

Market research publisher Packaged Facts estimates that online sales accounted for 20% of total pet product sales in 2019, with average online spending per shopper totaling $744. The firm predicts the percentage of pet product sales that take place online will steadily increase over the next few years, hitting 23% in 2023.

In short, what these numbers are telling us is that there are huge growth opportunities for e-commerce companies like Chewy.

The Company

Of the estimated $75.38 billion spent on pet products in 2019, 42% of that was spent of pet food, while another 22% was spent on supplies and over-the-counter medications. In other words, the kind of things you can buy on Chewy.com.

I’ve been a Chewy user for years, so I’ve witnessed the site’s growth first-hand. In fact, every time I visit it, the selection appears to have expanded.

I can also attest to Chewy’s competitive pricing and excellent customer service, which is available 24 hours a day.

These factors have combined to help this online retailer become a powerhouse name in the pet supply world. In fact, according to eMarketer Retail, Chewy has surpassed Amazon (NASDAQ: AMZN) in terms of pet food market share.

Chewy’s most recent earnings report offers a glimpse into how fast the company is growing.

In December 2019, the company reported that fiscal third-quarter sales jumped 40% year over year to $1.23 billion. This beat the consensus estimate, while the per-share loss was smaller than expected, coming in at $0.20. And management raised its revenue outlook for the full year.

What’s more, gross margins for the quarter increased 410 basis points over the previous quarter to 23.7%. And the number of active customers — those who have placed an order within the past year — jumped 33% year over year to 12.7 million.

So, while the company is not yet profitable, it is growing revenue and customers at double-digit clips, while improving margins, which should translate into an improving bottom line. I expect the company to be profitable in the next two to four quarters.

And while I do not want to speculate too much, I believe CHWY is a possible takeover target this year or next.

The Stock/Chart

Chewy was acquired in mid-2017 by PetSmart for a reported $3.35 billion, making it the largest e-commerce acquisition in history up to that point. In June 2019, PetSmart spun off the company, which went public at $22 per share.

Shares spiked nearly 90% on CHWY’s first day of trading, hitting a high of $41.34. Some of that enthusiasm fizzled by the end of the day, and shares closed up around 60%.

As you can see in the chart below, the stock continued to struggle for months before bottoming out in mid-November and reversing higher. I view this rebound as a sign that investors, not speculators, are now coming into the stock.

Since mid-December, shares have been trading in a relatively defined range, which is perfect for an options-selling strategy. But make no mistake, these shares are volatile and can make outsized moves, especially around earnings announcements.

Given this, I plan to avoid holding a position through any earnings announcement, as it’s simply not worth the risk. But I do plan on capitalizing on post-earnings volatility, taking advantage of elevated option premiums. And speaking of premiums…

Option Chains/Premiums

Volatility in the underlying shares — earnings or no — provide ample opportunities to generate income by selling options.

CHWY’s option chains offer weekly expirations, and despite it being a relatively young stock, there is enough liquidity to make entering and exiting trades easy.

So far, I’ve traded CHWY three times across my services, and each one was profitable, generating a total of $157 in cash.

The average cash return per trade was 1.18%, which may not sound all that exciting. But when you factor in that those trades were open for an average of just seven days, that puts the average annualized return at 95%.

CHWY is a bit unusual as a recommendation for one of my top income stocks, as it has yet to turn a profit. But I see huge upside over time in terms of revenue, profits, customers and share price thanks to the strength of the pet retail sector.

My plan is to take advantage of this by selling short-term options to continue to generate double-digit annualized returns on my cash.

 

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About The Author

Michael Shulman is a 30 Year Veteran of the financial markets – as a trader, a financial analyst, a financial writer and most recently as an educator.

Mr. Shulman made his first option trade in 1985 – COMPAQ Computer calls – a position that expired worthless. His second trade broke even; the third brought him a year’s salary, a near twenty to one return on his investment. Michael has never looked back. He entered the financial publishing business formally in 2001 as director of research for ChangeWave Research’s institutional research business and as the writer and editor of Hedge Fund Investing.

He has published two books – Sell Short and Made in America – both of which can be found on Amazon.com and is a frequent contributor to reputable financial sites like Seeking Alpha, MSN, MainStreetInvestor, and Traders Reserve.

His trade recommendations in his Options Income Blueprint, Perpetual Income Portfolio Club and Income Masters services maintain a 98% success ratio, meaning his trades produce the expected income 98% of the time. No one’s perfect.