Description

Executive Summary

• The stock is trading at all-time high with an excessive valuation of 1.4x EV/Revenue, partly elevated by a temporary short squeeze.

• Significant revenue growth artificially driven by paying for it through advertising.

• No visibility to generate sustainable positive cashflow given high customer acquisition costs, low retention rates and infrequent purchasing patterns habit.

• Acquisition costs reported by the company underestimate true spending by company to add new customers and drive recurring purchases from existing customers.

• Lackluster Q1/2017 performance with the second-highest cash burn rate reported to-date.

Overview

Wayfair shares are trading at all-time high (over $74, implying at an Enterprise Value of ~$6.2B) on the back of what appears to be a temporary short squeeze. Year-to-date, the stock has more than doubled. We highlight our short thesis throughout the rest of this report.

Wayfair is an e-commerce platform which offers customers a large online showroom of household merchandises including furniture and home appliances. The products are sourced from third party suppliers and processed and shipped by Wayfair to customer homes. The company was founded in 2002, went public in October 2014 and is currently a >$6.4B market cap company.

However, despite achieving impressive top-line growth, Wayfair has failed to generate positive cash flow or EBITDA and is unlikely to do so any time soon. And while it is easy to be swayed by the artificial growth (explained below), the key question that remains outstanding is whether Wayfair provides lasting value to its customers and its shareholders.

Customer Acquisition Costs

The company has for a while engaged in an endless advertising campaign to acquire customers.

As of March 2017, Wayfair had 8.9M active customers with an LTM net revenue of $394 per Active Customer and an average order value of $223. Similarly, as at December 31, 2016 (YE), there were 8.25M customers, 6.0M of which were reportedly newly acquired (refer to Q4/2016 investor presentation). While this may seem impressive at first, it does point to a few concerning observations:

1. Existing customers transact very sporadically

This makes sense if you think about the low frequency of big ticket item purchases such as furniture. Wayfair defines active customers as those who transact at least once during the preceding twelve-month period. Hence, the numbers highlighted above suggest that out of the 5.4M active customers that Wayfair had in year-end 2015, only 2.2M (~40%) transacted in 2016 (see Table 1), which is very low. Additionally, repeat customers accounted for only 58% of orders in Q4/16 vs. 71% for Overstock.com.

2. High cost of increasing or even maintaining the customer base

The implication is that Wayfair spends egregious amounts on marketing to “acquire” new customers ($66/customer in 2016 – see Table 1), partly to replace the customers base that becomes inactive which provides the perception of an impressive top-line growth. In 2016, Wayfair spent ~$400M on new customer acquisition (~$207M of which was spent on replacing customers that had become inactive). This is a very expensive customer retention strategy which ultimately stalls or fires back, unless there are adequate repeat transactions from each customer. In comparison, the customer acquisition cost for Overstock is $38/customer.

Additionally, the company provides a misleading illustration in its presentations with reference to customer acquisition costs. Based on management’s definition, customer acquisition cost only includes Direct Retail Ad Spends. While, we agree on the exclusion of Partner Ad Spends, we believe it is misleading to leave out other related G&A expenses including Merchandising, Marketing and Sales, as these are labor-related expenses that directly help in driving customer growth and the revenue base. Also, the following disclosure from the company’s 2016 10K emphasizes the direct relationship between these items and the customer base retention and growth: “Sales, marketing and merchandising expenses are primarily driven by investments to grow and retain our customer base. We expect merchandising, marketing and sales expenses to continue to increase as we grow our net revenue.”. However, the problem is furniture is so seldom purchased that users will use any site when they next come back to buy.

Another issue with Wayfair’s illustration of acquisition cost is how it doesn’t account for repeat customers by allocating all Direct Retail Ad Spending only to new customers. While excluding repeat purchasers from the calculation would overestimate the cost per customers, it can intuitively help justify management’s strategy and upside in the long-term. To elaborate further, excluding repeat purchasers from the acquisition cost metric would mistakenly imply that repeat purchases are driven at no cost which may drive uninformed investors to believe that if the company is able to ultimately grow its customer base to a large enough threshold, the economies of scale can help management achieve enormous organic growth. Yet, companies especially in the e-commerce sector, even those as established as Amazon, have to continuously spend on ads to stimulate repeat purchases.

3. Average order values and margins do not keep up with all-in costs

According to the Q1/2017 presentation (shown in Table 1), contribution margin for customers is on average $79 or 20%, which compared with the reported acquisition cost of $66 implies the advertising spend is an accretive strategy by management. However, once we include the G&A items outlined above, we get a total acquisition cost of $95 which exceeds the current contribution margin of $79 by each customer. Based on 2016FY financials, for Wayfair to breakeven, it needs to achieve an annual Direct Revenue per Customer of at least $477 (see Table 2), which implies a minimum of 2.0 repeat purchases per new customer annually, +20% above what it is currently generating and much higher to support current valuation. This analysis is illustrated in Table 2 below.

Similarly, management recently highlighted a long-term EBITDA margin target of 8-10% which if achieved can result in sizeable annual cash flows. However, included in this EBITDA expansion is the assumption that advertising costs will decrease from +12% to 6-8% (see Q1/2017 investor presentation). Given the substantial portion of inactive customers, it is very dangerous to assume no retention downside in cutting advertising expense by nearly 50%.

Unless Wayfair can figure out a strategy to retain customers and drive repeat purchases at lower marketing and advertising costs, it won’t become profitable and the competitive landscape is not becoming any easier as highlighted below. After ~15 years in the business, the company is only able to retain ~40% of customers (based on 2015 retention), what are the chances they reverse this trend!

Threat of Competition

The home furnishing and household goods market is very fragmented with relatively easy access to products. The industry is also highly competitive and is continuously advancing. Competitors include other e-commerce players such as Amazon, eBay, Overstock as well as offline retailers including furniture stores, Big Box retailers (e.g. Bed Bath & Beyond, Home Depot, IKEA, Lowe's, Target and Walmart), department stores and specialty retailers (e.g. William-Sonoma and RH).

Many of these competitors are larger and better capitalized than Wayfair which makes it challenging for Wayfair to gain market share and differentiate itself. Specifically, Amazon can pose a huge threat to Wayfair, as it certainly has the experience, resources and capital to disrupt the landscape if it does ultimately decide to ramp-up its presence in the furniture market.

Other competitors including William-Sonoma and RT had 52% and 44%(2) of their revenue in online sales respectively in their most recent quarter. These competitors have better margins compared to Wayfair as they are not just middlemen.

2. Represent Direct Sales which includes sales through company websites as well as through company’s source books and phone orders

Liquidity

Wayfair currently has a cash and cash equivalent balance of $277M. However, it also has a significant amount of Account Payable on its balance sheet (over half of its liabilities) which may tie up some of this cash, in addition to negative impact on cashflow from working capital changes in the latest quarter. Additionally, with no visibility to near-term positive cash flow and assuming a run-rate cash burn of ~$270M (based on grossed-up Q1/17 cash flow statement) or higher due to increased efforts to drive revenue, Wayfair would have to access the public market in the near-term to support its growth strategy.

Q1/2017 Results

While Wayfair reported strong revenue growth, it performed poorly on metrics that we believe are leading indicators of future profitability. First, Average Order Value dropped by 6% YoY and missed street consensus by 4%. This together with a decline in order frequency signal further difficulty in retaining active customers. On top of this, company’s cost of customer acquisition increased by 39% YoY, which supports claims that the company is buying its revenue growth. In fact, growth in operating losses was larger than the revenue growth (34% vs 29%), and the company missed street expectations on key profitability metrics including EBITDA by ~13% (($35.9M) vs ($31.9M) and on Operating Profit by ~9% ((56.2M) vs. ($51.7M)). Lastly, Wayfair had its second highest cash burn rate reported to-date with ($46M) of CFO.

Valuation

The company is currently trading at 1.4x sales which relative to peers (~0.7x average (3)) seems overly inflated. Overstock, one of Wayfair’s closes peers, is trading at ~0.2x sales despite its small yet positive EBITDA margin. This makes sense if you think about it. Wayfair and OSTK report gross sales, but net sales are the key as they are really just pass-throughs. Hence, no way it should trade at 1.0x revenue or higher.

Another alternative for analyzing the valuation is on a customer basis. Based on this metric, Wayfair is trading at >$700 EV/Active Customer which similar to its EV/Sales metric is very large. The excessive valuation metric is further highlighted if we compare this to Annual Direct Retail Revenue per Customer of $394 and Average Order Value of $223 (based on Q1/2017 results). The valuation implies full conviction that active customers would engage in ongoing repurchases and sustain long-term value. However, unlike subscription-based models, where investors tolerate negative cashflows in early stages of development to attain a large customer base and generate adequate recurring revenues, long-term value extraction rarely exists in large-ticket transactional businesses. This is especially true for Wayfair which had only 41% of its 2015 customers remain active in the following year. So, unless Wayfair can demonstrate strong retention levels and repurchase patterns, such a high valuation per customer is unjustified.

3. Includes Overstock, William-Sonoma and RH

Risks to our Thesis

We realize that as with any investment, there are certain risks that can work against or delay our thesis. The stock is highly favored by sell-side analysts due to the company’s ability to penetrate a large addressable market and drive a robust revenue growth profile. For reference the company has grown from a $600M revenue base in 2012 to LTM revenue of $3.6B and Analysts expectations of >$8.0B revenue by 2020.

The biggest risk to our thesis is if Wayfair continues to post strong revenue growth from Direct Retail and potentially drive the stock further up and investors continue to ignore profits. However, as we highlighted in our report, revenue growth does not always translate into cash flow generation and shareholder return and at some point, shareholders will demand a clear path to achieving the latter two milestones. Also, few companies have lost money to greatness and we don’t expect Wayfair to follow this model but there is the risk that we are wrong.  

Another risk to our thesis is if Wayfair miraculously figures out a strategy to significantly increase the frequency of purchases and hence validate a long-term value to customers. We do not see an easy or even an attainable solution on this issue as part of it relates to consumer behavior and the industry which Wayfair functions in, both of which Wayfair does not have much control over.

Another potential risk is if the company gets acquired by a larger retailer who is looking to boost its online presence. Rumors started circulating last month that Walmart may be looking to acquire Wayfair as part of its broader strategy to enhance its e-commerce operations, which included its $3B acquisition of Jet.com as well as others including Shoebuy, Moosejaw and Modcloth. Sell-side analysts have also highlighted Target, Bed Bath & Beyond, Home Depot and Lowe’s as other potential acquirers. However, we argue that acquisition of Wayfair is substantially larger than any other acquisitions that these potential acquirers including Walmart have completed to date and with the stock price at its peak, this is not a very highly probable scenario.   

Lastly, a bet against Wayfair could be perceived as a broader bet against e-commerce which can be risky and an uphill battle to start if the sector continues to outperform. Similarly, an outperformance by retailers can also provide a risk to our thesis.

Catalyst

Quarterly misses on revenue growth or margins

Increase in customer acquisition costs

Growth slowdown or decline in number of active customers

Decline in orders from repeat customers including order frequency or average order value

Increased competition in the sector