Description

Investment Thesis

Riding on the coattails of the COVID-19 pandemic, Wayfair’s stock has been on a massive surge in the past three months. The favorable conditions created for digital business models have propelled Wayfair’s stock by almost 800% since March 2020, alongside other digital companies such as Zoom, Netflix, and Peloton. However, our diligence suggests that the benefits from the pandemic are minimal compared to the persistent fundamental issues underlying the business. The long thesis also fails to capture the risk of rising digital adoption amongst competitors because of the pandemic that will likely start to deteriorate Wayfair’s competitive positioning. We believe that as the incremental benefit from COVID-19 fades, the market will eventually catch up with the underlying problems of the business. Here are three reasons why we think Wayfair presents a compelling short opportunity: 

1. One-time benefit: We believe an incremental ~$100/share(~$10B) of equity value has been created simply due to the advent of COVID-19 and the resulting pull-forward of sales. The stay-at-home orders have driven consumers to shift discretionary spending focus on household items, including furniture and decorations.  Although a significant tail to Wayfair, this has created only a one-time benefit, and while this impact could last a few quarters, it is not a permanent or indefinite structural change in the business or consumer behavior that can improve long term prospects of the company.  In other words, there has been no meaningful permanent change in consumer behavior and purchasing habits including repeat rates, average ticket prices, or Wayfair’s profitability measures to justify the current valuation. The current top-line growth is simply unsustainable and once the transitory benefits fade, the underlying issues from the pre-pandemic times will creep back up in the company’s financials.
2. Company’s pivot: COVID-19 gave the company’s bottom line a minor benefit as the company was able to continue its reduced marketing spend (announced before the pandemic) while attaining a one-time influx in sales. This provided support for Wayfair’s recent business plan pivot, which is to focus on the bottom line. Most companies that shift their business plans outside of a natural business evolution often fail and the management’s track record of failed promises does not instill confidence that Wayfair will be an exception. We expect a company that has benefitted from abusing the capital markets, to be unlikely to succeed in this new pivot. 
3. Rise of competitors: Competitors are seizing the opportunity to capitalize on rising digital trends and progress by the likes of William Sonoma, Restoration Hardware, and others will likely reduce Wayfair’s initial competitive strength post-COVID (note: the continued rise of Shopify can hurt Wayfair).

Busness Description

Wayfair is one of the largest online retailers for home-related products ranging from furnishings to décor to kitchen equipment. The company was founded in 2002 by CEO Niraj Shah and his classmate Steve Conine as CSN with Wayfair.com being launched in 2011. The company claims to have over 18M products from over 12,000 suppliers. The company’s primary target market is 35-65-year-old women with annual incomes between $50,000 to $250,000 who, as the company claims, are “underserved by traditional brick and mortar and other retailers of home goods. While a large portion of their products are shipped directly by its suppliers, the company has invested in its own logistics network. The company also offers products to customers through a family of 5 websites, with Wayfair.com representing a large portion of their revenue. As of December 31, 2019, the company had 16,985 full-time employees. The company operates in a very competitive space facing competition from traditional furniture stores such as Ashley Furniture, Big Box  Retailers such  as BB&B, IKEA, Walmart, etc., Specialty retailers such as Williams Sonoma, Restoration Hardware and At Home, Online Retailers such as Amazon and lastly International competitors like Leon’s and Canadian Tire

One-time Benefit: Cannot Mask Pre-COVID 19 struggles

While Wayfair has historically been liked by long investors for its top-line growth, the appeal started to fade in the two-quarters preceding COVID, which drove a steep decline in the stock price before the pandemic. The company experienced material recurring deceleration with growth declining by almost half in Q1/2020 and Q4/2019 vs the preceding eight quarters (shown in Exhibit 1).). One of the major headwinds faced by Wayfair in the few months before the pandemic was the tariffs resulting from the US-China trade war. With the company importing close to 50% of its goods from China, tariffs raised prices for merchandise and negatively impacted consumer demand. Sales growth was further deteriorated because of an increase in customer acquisition cost to almost $54, a stagnation in orders per active customers, and an overall decline in category growth.While the pandemic has created a resurgence in the growth thesis, we believe this is only temporary. 

In the last 4 months, consumers have been faced with an unprecedented shock to their lifestyle that has shifted their spending focus. On one hand, people are spending more time shopping online given stay-at-home orders and limited shopping alternatives, with a focus on improving home aesthetics and functions given the excess time spent at home.

On the other hand, what is important to understand is that Wayfair’s growth story will likely come to end once the economy opens more widely. As most people start to go back to work, and brick and mortar stores re-open, purchasing habits and spending focus will revert to more normalized (pre-COVID) levels. Consumers who did not order from Wayfair during the lockdown are much less likely to use the platform after, given a wider array of available shopping alternatives and budget re-allocations. Similarly, repeat purchases are likely as not bullish as some long investors are hoping for. In Q3/2018, repeat customers accounted for 66% of the company’s total sales in that quarter. In Q3/2019, this number was about 67%. In many earnings calls and analyst days, the company mentions the importance of repeat rate yet Y/Y, the company’s repeat rate only grew a mere 1%. Even during the pandemic, this rate only spiked to 70% during Q1/2020. That means that the number of customers who have chosen to shop again at Wayfair during the lockdown is not that much higher than the repeat customers during “normal” times. In a May 2020 consumer survey conducted by Piper Sandler during which consumers were asked what brands they would consider for home furnishings, 46% responded with Amazon compared to only 28% for Wayfair. Even traditional big-box retailers such as Walmart and Target ranked ahead of Wayfair in the survey.Lastly, with recessionary outlook becoming direr and government stimulus payments and extended unemployment benefits potentially coming to an end, discretionary spending, particularly on medium to large ticket items, will start to take large hits. 

Exhibit 1

Exhibit 2

Profitability should be another major point of concern for investors. However, what is even more concerning is the management’s failure to deliver on its continued promises of improvement in margins. Since 2017, the management has continuously reiterated visibility towards meaningfully higher gross margins, but little to no improvement has been achieved with gross margins staying range-bound between 22.8%-24.9% (Exhibit 2). 

• In their FY2017 earnings call, the company mentioned how that “Now the way our business works is as we unlock more scale, we unlock more margin, right” and subsequently “And so I think as we continue to ramp those businesses, we should be able to unlock more gross margin there”. 
• Similarly, in its FY2018 earnings call, the company talks about how in their long term model the target is “We show a gross margin number of 25% to 27%”. “So the way to think about the future is that gross margin will rise”. 
• Lastly, in their most recent FY2019 earnings call, the company mentioned how “When it comes to gross margin, even though it's never a straight line, we continue to expect substantial gains from a few factors”

Exhibit 3

Exhibit 4

Wayfair’s declining EBITDA margins are another major point of concern as demonstrated in Exhibit 3. From Q1/2018 to Q1/2020, EBITDA and adjusted EBITDA (EBITDA + equity-based comps) margins decreased from -5.5% to -8.4% and from -3.8% to -5.8% respectively. The EBITDA margin was worse in the second half of 2019 (before the pandemic even started impacting their business) ranging between     -6% to -9%. The reason for this decline in margin is due to the growth in operating expenses (Exhibit 4), which have almost doubled since Q1/2018. The company’s advertising expense was growing at an average sequential rate of almost 10% until Q1/2020. A similar increase can be seen in the company’s Selling and G&A expense which was growing at an average rate of 12%. In the pursuit of growth, the company has been heavily spending on advertising and other operating expenses, which as led to the disappointing EBITDA margins. With the rising competition in digital sales, especially following the pandemic (as elaborated in more detail below), it is unlikely that advertising, selling and G&A expenses will come down. If anything, as the low hanging fruits are collected during lockdowns, onboarding of marginal customers will require an even greater effort.

In their FY2019 call, management mentioned how they expect adjusted EBITDA profitability moving forward but the fact is, the company has not been able to deliver on its previously stated targets and investors should be highly skeptical and cautious, especially considering the rate at which operating expenses have previously grown. For perspective, the management has been highlighting a long-term target of 25-27% GM and 8-10% EBITDA margins since 2015 but is nowhere near achieving these on a sustainable basis after over 5 years. 

At a time of massive economic uncertainties and a potential credit event, investors should also worry about Wayfair’s deteriorating working capital trend.  In the last 3 years, the company’s days inventory and days sales outstanding (Exhibit 5) have increased while the company’s days payable outstanding has stayed relatively flat, between 39-45 days. In the current COVID environment, the latter metric may decrease drastically as suppliers demand faster payments because of liquidity concerns. Sequentially and Y/Y, the company’s quick and current ratios have decreased since Q3/2019, meaning the company now has less cash and other current assets on hands to meet its liabilities. 

Exhibit 5

Based on the information above, while the pandemic will likely provide some benefits to the company in the short term, these are only transitory and there are far greater long-term fundamental issues that investors should consider.  In our view, these benefits are not nearly enough to justify an ~800% increase in market value when the company’s EBITDA margins have declined, the gross margins have stayed flat and revenue growth has slowed down to half the rate it was only a few quarters ago.  

Company’s scrambled pivot in its business plan: Risking growth for a temporary lift in profit  

Following years of positioning Wayfair as a growth story, and building a hefty valuation around it, the management has more recently tried to slowly pivot towards cost-cutting and bottom-line focus. While this may seem like a natural progression towards the next stage in the evolution of the business, the transition is highly pre-mature without a clear-cut strategy in place and is merely being implemented as a tactic to divert attention away from the deceleration in revenue growth. As we explain, sacrificing growth for cost-cutting measures, harms Wayfair’s business model which has traditionally been successful because of its ability to grow revenues and should be looked upon cautiously by investors 

For example, in February 2020, Wayfair laid off 550 staff members and placed an additional constraint on deploying marketing dollars to boost profitability. This comes after the company bloated its headcount from 8,753 in Q1/2018 to 16,985 by the end of Q4/2019. It is hard to believe that the company will be able to get significant cost savings without substantially reducing its headcount. However such cost-cutting initiatives pose a risk to the company’s growth. In management’s own words, “While we admit that this can run the risk of sub-optimizing growth, it's an additional mechanism to keep the quantitative framework tight and healthy.  Management also mentions in its Q1/2020 call that “We still have thousands of people working on initiatives that due to their early-stage nature show very little gains compared to large long-term potential. For example, the company’s headcount for its Marketing, Engineering, and Technology employees has grown from 4,730 to 8,034 in the period above. Based on management's indication, many of these employees are working on initiatives that could be very good for the company. However, if management wants to cut opex further, it will have to cut headcount further. This leads to a suboptimal and short-sighted allocation of resources because while the company is saving on opex, it is missing out on the long term potential of many such initiatives which would save the company further dollars. 

The second area that the company has been trying to control has been their advertising spend. In their Q3/2019 earnings call,  the company said that they expected a Y/Y deleverage of 50 to 100 basis points in advertising expense when in reality, Q4/2019 advertising expenses increased by 100 basis points. Since 2017, advertising expense has consistently stayed in the 10-12% of revenue range even when revenues have increased from $4.7B in 2017 to $9.1B in 2019. In the last few quarters, as sales decelerated, the company was still growing advertising spend, showing weakness in its ability to efficiently distribute ad dollars. Amidst all this, the company’s LTM orders per active customer metric has stagnated at 1.86 and so has direct retail revenue per active customer at ~$449. This speaks to the low frequency that is inherent to the category and leads Wayfair to have to reach out constantly for new customers. However, the only reason Wayfair has been able to get new customers is because of its ad spend.  This means that if Wayfair continues down the path of cutting ads, it will seriously jeopardize its top-line growth as it has no other way to acquire new customers. Cutting ads also does not suit the company well, especially with competitors like Amazon waiting to take customers from Wayfair.

There is a reason why companies who commit to a focused strategy over long periods succeed. When a company starts to transition to a new strategy, success often depends on the ability of management to execute and sometimes a failed pivot, can cost shareholders significantly. One such example is the company Blackberry. The company ruled with its keyboard-equipped handsets that became the corporate phones of the time. However, after facing competition from Apple and Google, the company released “The Storm”, in an abrupt and sloppy rollout to pivot to the touchscreen market and failed miserably (Source). The handset had no wi-fi, suffered from software glitches, and the display made messaging functions very frustrating. This started the company on a path to decline, with future products barely getting any sales traction.

A similar strategy shift is occurring at Wayfair, from a focus on sales to the bottom-line. While for many businesses this is a natural transition towards a mature value-driven phase, in the case of Wayfair, it’s a scramble to focus on the bottom line as growth decelerates. However, as the company looks to cut costs in areas such as headcount or advertising, they will likely see negative impacts on the ability to get new customers and grow the top line. By pivoting, Wayfair has shown huge fundamental flaws in its business model that will negatively impact shareholders in the near term.

It is also important to note that growth-focused companies trade fundamentally very differently compared to profit-focused companies. Whether this scrambled strategy proves successful or not, we believe this pivot will create a need for a correction in Wayfair’s value. 

Rise of competitors:  Threatening Wayfair’s only competitive advantage 

Similar to many other “stay-at-home” stocks like Zoom, Netflix, and Peloton that have benefited from the government-enforced lockdowns, Wayfair has seen a surge in interest given its large online presence and no brick or mortar locations to incur net costs during the lockdown. Many of Wayfair’s competitors like IKEA, Bed Bath & Beyond, Willian Sonoma and Restoration Hardware have struggled because of their physical locations and the financial impact of losing customers and incurring rent expenses during shutdowns. Wayfair has built a brand over the past few years as one of the largest online retailers of furniture and home décor, but it is only a matter of time before other brands establish their digital footprints. The lockdown has given Wayfair a near-term boost in business but it has also given its competitors a chance to expedite their own rollout of digital strategies (many of which have been successfully executed thus far) that will slowly become a core part of their business models, in the post-COVID era.

One such competitor is William Sonoma. Even before COVID-19, the company’s 2019 presentation (Source) captured their strategy perfectly: “We are a digital-first company with retail stores as a competitive advantage”. In its Q1/2020 earnings call, the company mentions how they are a top 25 online retailer in North America, with a YTD E-commerce growth of 10% (as of September 2019) and digital revenue contribution of over 55%. Even amidst the pandemic with more than 616 stores closed for over half of Q1, the company delivered 2.6 % comp growth. The company further mentions how the “strategic investments” they made over the years in digital have allowed them to shine in this period of disruption. The company has also invested in creating new consumer experiences such as online Design Chats, Virtual Design Appointments, and 3D visualizing technology. Lastly, the company has seen a dramatic acceleration in its online KPIs such as traffic, conversion, and customer growth. 

RH is another company that has started making the shift towards a digital platform. In their most recent Q1/2020 earnings call, the company talks about the big investments they are making in digital including the hiring of a Chief of Digital Experiences, and investment plans on completely reimaging the website. As a result of the expedited online shift, the company is targeting a digital revenue contribution of 30% compared to 17% in the past year. 

While these are specialty retailers that compete with Wayfair, some of Wayfair’s other competitors have also adopted or started focusing on an online strategy. These include businesses such as:

1. Bed Bath & Beyond: According to a recent press release, the company mentions how “Traffic to Bed Bath & Beyond website and mobile app is up approximately 30% and digital sales have doubled” (Source)
2. Walmart: For the last few years, the company has invested heavily in e-commerce. In the first quarter of this year, online sales rose 74 % as customers stocked up on items including home furnishings and office furniture (Source)
3. TJX Companies: The company highlighted in their Q2/2020 earnings call recently that they are seeing very strong demand for HomeGoods

These are only select examples of competitors shifting towards digital platforms and most of these initiatives started before the pandemic and are only being accelerated by COVID spread. Meanwhile, Wayfair is being valued as the only “quarantine” furniture retailer when that is simply not true. As shown by the examples above many of the competitors are thriving and it is only a matter of time before they catch up to Wayfair. Thus, we believe the valuation of Wayfair does not price in the very real risk of rising digital strategies by competitors. 

As the economies open and consumers gradually revert to old habits, the competitors with omnichannel capabilities can capture a larger portion of the consumer spending than Wayfair, given their brick and mortar presence while maintaining exposure to the digital trend. It’s also important to note that household goods and in particular larger items like furniture or decorations are still preferred by many to be purchased in-person due to the ability to better assess quality and size. Also, it’s easy to see how some shoppers may revert to brick-and-mortar shopping after months of spending time at home. This can further be exacerbated by massive discounts as brick and mortar stores liquidate their winter and spring inventories. The rebound shopping trend can favor the competition better than Wayfair as the economy opens up.

Massively Expensive Valuation

Within its peer group, Wayfair is the only company with a 2019 EBITDA loss and analyst consensus (considering benefit from COVID), expects EBITDA of only $9M in 2020, and $117M in 2021 (0.1% and 0.8% of revenue respectively). This means the company is currently trading at an egregious multiple of 208.04x 2021 EBITDA when the peer group trades at an average of 9.06x 2021 EBITDA. Even on a revenue basis, Wayfair is overvalued, trades at 59% above the peer group’s average on a 2021 basis. 

Risks

• Work from home benefit: One of the risks to our thesis is if COVID-19/Quarantine measures last longer than expected (full reopening not happening till late 2020/early 2021) and the risk of a second wave is possible. This will reiterate the lockdown thesis, pushing up the price but also possibly increasing users to Wayfair and impacting its fundamental value.  The work from home benefit will inevitably wear off and that will be the time to initiate or double down on a short position 
• The second risk is if the cost efficiencies put in place by management succeed and the company increases its gross margin/ achieve positive adjusted EBITDA. While this is possible, management has failed to deliver on their promises in the past few years which makes us doubt their ability to achieve these bottom-line promises. Also, one of the key factors in online shopping will be delivery but COVID has been impacting the delivery supply chain and will possibly increase shipping  and freight costs which can harm the company and mitigate this risk. 

Catalyst

• The reason this trade is interesting today or very soon is because Wayfair is trading at a decent EV/Sales in the context of its history and the stock is priced to perfection.  The current one-time pull forward of sales will not last for long and as soon as the trend turns negative, investors should consider ramping up short positions on the stock..Investors should consider initiating a short position on the earlier of 1) the one-time benefit from COVID-19 sales starts to fade, 2) competitors continue to migrate online, 3) a vaccine has been developed (perhaps a 2021 event), 4) any combination of the aforementioned
• As fatalities trend downward and the US continues to reopen, it should pose downward pressure on Wayfair’s lockdown story and whether the company will be able to see any meaningful impact on its annual financials (lockdown essentially lasted one quarter) 
• The economic impact of COVID has been devastating and while there might have been a pop in Wayfair demand initially, as layoffs/unemployment continues to rise, spending on discretionary household items will be impacted (plus a potential decrease in real estate sales) will create downward pressure for Wayfair’s COVID story (even if a lockdown continues)  as valuation starts to normalize