For the second quarter in a row, Chewy (NYSE: CHWY) stock soared on its earnings report.

On Wednesday, shares of the online pet products seller jumped 11% after it posted modest revenue growth in the second quarter, but profits soared as it delivered strong margin expansion.

Revenue rose 2.6% to $2.86 billion, matching estimates, while adjusted earnings per share jumped from $0.15 to $0.24, ahead of the consensus of $0.01. That's the third straight quarter the company smashed earnings estimates.

The surge on the bottom line was paced by its gross margin, which expanded by 120 basis points in the quarter to 29.5%. The company credited the improvement to growth in its higher-margin businesses, better pricing, and staying competitive in key categories.

Chewy also made improvements in operating expenses, which fell 50 basis points as a percentage of revenue from 28.9% to 28.4%. It's improved operating efficiencies, with 40% of order volume now automated.

As a result, adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margin expanded 190 basis points to 5.1%, or $145 million in adjusted EBITDA.

Image source: Getty Images.

Margin improvement is impressive, but...

Chewy deserves credit for its margin expansion, but not everything is going smoothly in the business.

Its revenue growth has slowed for the last seven quarters in a row through the latest report, coming in at just 2.8% in the second quarter. Customer growth also stalled as total customers came in at 20 million, which was essentially flat from the quarter a year ago.

The pet products e-commerce leader finished fiscal 2021 with 20.7 million active customers, which declined to 20.4 million in fiscal 2022 and 20.1 million in fiscal 2023. As it stands, Chewy is on track for the third straight annual decline in active customers.

Chewy has succeeded in growing net sales per active customer, a credit to its ability to expand relationships with its current customer base as it invests in repeatable categories and adds new premium product lines, but the business would be healthier with customer growth.

The pet products industry has struggled since the end of the pandemic, following a surge in pet adoptions during Covid. Chewy also benefited from the pandemic as an e-commerce company as consumer spending shifted to the online channel.

Chewy forecasts revenue growth of 4% to 6% for the year, but that includes an extra week in the calendar, meaning that growth would be just 2% to 4% without it.

The biggest question facing Chewy

Chewy stock has now essentially doubled from its low point this year, and based on its quarterly result, the stock looks reasonably priced, especially if it can report more quarterly earnings results like the one it just did.

Based on its forecast of $538 million in adjusted EBITDA this year, the stock is valued at 21 times this year's expected EBITDA.

Chewy's business also has a number of attractive attributes, including its base of autoship customers, which provides a highly predictable revenue stream, and it's the clear leader in pure-play pet products retailers.

However, the biggest question at this point is whether the company has reached a ceiling in customer growth. Three years of a declining customer base looks like a red flag, even factoring in the pull-forward effect of the pandemic.

Peers like Petco, which also surged during the pandemic, are now struggling as well, and Petco's revenue fell 1.7% in its most recent quarter. Other pet food companies, like Freshpet, however, have continued to deliver strong growth.

Chewy management seems to think the long-term trend of growth in the e-commerce sector will continue and said that traffic on the website was returning to growth.

At this point, if Chewy can return to reasonable growth, the stock looks like a buy based on its improvements on the bottom line. However, for now, investors are better off on the sidelines until the company can demonstrate that it can grow its customer base again.

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