Description

We believe the setup is favorable to short Wayfair.  I grant you that Wayfair is a real company at the same time there are dozens (more likely hundreds) of IPOs and SPAC trading on nothing more than a hope and a prayer.   Instead of focusing on whether Joby can hit its 2026 guidance and eVTOL / air mobility becomes a thing, we’ll just try to focus on the here & now.  Note that this is also not a unique  thesis as it was written up on VIC a year ago early on in the pandemic, we just think the timing has improved.   

For reference, Wayfair is an online home furnishing store which continues to be run by its co-founders Niraj Shah and Steve Conine.  The company has one of the largest online selections of furniture, décor, housewares and home improvement products, with over twenty-two million products from over 16,000 suppliers.  In addition, they built a portfolio of over 100 house brands.   Roughly 80% of the business is in the US.  Wayfair’s target customer has an annual household income ranging from $25,000 to $250,000.  

Macro Setup Pertaining to Wayfair

Deficits / Goods vs. Services

Going into 2020, very few would have ever imagined that a pandemic would create an enormous tailwind for goods producers and retailers of all kinds.  E-Commerce is an obvious beneficiary, but the combination of locking people in their homes and unprecedented fiscal and monetary stimulus created an enormous boost to corporate profits in combination with a significant wallet share shift to goods from services.   First, from a macro perspective, profits are derived from net investment less household/government/foreign savings.   WIth government deficits reaching an annualized rate of (10%)-(25%) of GDP throughout 2020, it is unconscionable to think that deficits anywhere close to this level can be sustained despite efforts to push through trillions of incremental fiscal spending (to be spread out over years).  For context, the US effectively spent over $5 trillion to fight COVID, or more than $1 trillion in today’s dollars that we spent fighting WWII.   Is it any wonder that the economy, consumer spending and corporate profits rebounded like a rocket ship and people are singing songs about Dogecoin, HODLing and Elon Musk taking them to the moon?   The inevitable declining fiscal support to the economy will act as a drag on economic growth and corporate profits prospectively.   

Second, as shown in the chart below, experiences such as concerts/travel/dining over ‘things’ was a very long-running secular theme pre-pandemic.   The pandemic dramatically reversed these trends, which we believe is likely to prove transitory -- after all how many bikes/electronics/couches do people really need?  Hoarding these items isn’t quite as useful as toilet paper.   So when we combine these two factors (government support + wallet share shift), we saw an incredible surge in sales/profitability in certain industries including companies such as BGFV that had long suffered pre-pandemic.  Note the enormous and monumental margin shifts that took place across retailers within the goods sector….is this just a coincidence?  Did management of these companies wake up and instantaneously figure out how to triple the profitability of their businesses overnight?   Color us skeptical.

Looking forward, high vaccination rates coupled with natural immunity has likely caused Rt for COVID to fall below 1 such that cases should continue to decline.   As they do, we believe that the aforementioned wallet share shift seen during the pandemic is in the process of reversing.   Indeed, we are already starting to see signs of this in the data but believe it can and will accelerate going forward.  Interestingly, Ethan Allen noted (10/28) “The consumer interest will not be as strong going forward. We've got to work harder. We've got to be in a much better position. I would say that the easier days for our industry are over.”     Another obvious nuance is that companies more oriented toward e-commerce benefited disproportionately (especially early in the pandemic).    Within the furniture category, channel checks suggest that we are seeing  in-store shopping improve leading to a  moderation in online penetration.  Anecdotally, we saw on 10/28 that clear e-commerce ‘winners’ AMZN and SHOP reported weaker results, corroborating the notion that perhaps life can and will return to something resembling pre-pandemic.  

Freight & Logistics Nightmares

It doesn’t take a rocket scientist to see that freight and logistics are presenting significant challenges for the many industries currently.  Container rates are up 4x-5x.  Shipping contracts are not being honored at specified pricing without significant delays.   Ports are congested.  Delays are affecting demand for seasonal products.  The industry  has to deal with narrower selection and longer-than-desired lead and delivery times, which are unlikely to normalize until some point in 2022 (hopefully).  Wayfair is not impervious to these problems with a majority of inventory on its platform comes from offshore.   Container costs in certain instances have gone from $2,500 to $20k-$25k, creating a problem both in terms of availability but also cost.  

Implications of House Price Inflation

Without casting judgment, it is clear that the Fed is tolerating higher inflation as Chairman Powell awaits his re-nomination (likely after the “Build Back Better” fiscal plan is approved).  For understandable reasons they are choosing to emphasize employment over inflation within the dual mandate framework.   There are obvious consequences, however, which in this case has housing prices going vertical across the country.  Not surprisingly, consumer sentiment towards housing has soured dramatically and to a level not seen since the late 1970s/very early 1980s.  While it is certainly possible that the housing market will sustain its strength as we head into next year, we believe downside risks are growing for the industry.   Furniture sales are typically done in a frenzy as people relocate, so anything that slows turnover would be a negative.  Unless sentiment shifts or historical relationships break, the immediate future looks challenging...

Company Specifics

Third Party Data

Web traffic data for Wayfair in the third quarter is declining (20%)-(30%) y/y, which has continued into mid-October.  Over the last couple years, web traffic has had a strong correlation -- over 80% -- with the sales trajectory of the business.  Thus, when the company reports quarterly results next week we are very likely to see a material decline in sales.  Indeed, management indicated the business was running down in the teens to start 3Q when they reported second quarter results.   Despite easing base period comparisons, it does not look like the data has gotten any better.  For its part, Wall Street believes that after a hiccup this quarter things will be off to the races again with sales returning to 20% growth heading into 2022.  

Negative Working Capital

Wayfair historically has benefited from a positive working capital float.  In other words, Wayfair gets paid from consumers before it has to pay vendors.   This can help finance incremental growth when things are going well.  However when sales decline this cash flow dynamic reverses.  The company prepared investors last quarter saying “we tend to see net working capital outflows in quarters when revenue is sequentially lower.”  For reference, consensus currently models a ~($600) million sequential decline in sales from 2Q to 3Q 2021.   As if a warning to investors, management indicated they are “fully prepared” for negative free cash flow in 3Q.  Are investors fully prepared?

Gross Margin

Wayfair’s EV/Sales multiple is highly sensitive to gross margin (~65% correlation), which in itself is correlated with sales.  After showing limited signs of ‘scaling’ in the first several years as a public company, the company enjoyed a huge boost during COVID for the reasons mentioned herein.   That is now starting to reverse itself.  Having peaked in the 30% area, management highlighted inflationary pressure would cause gross margins to decline to 27%-28% in 3Q.   If anything, gross margin pressures have only intensified since the company last reported results.

Market Share Losses

While the market interpreted Overstock’s 3Q results positively, we are less convinced.   Overstock is operating at a gross margin that is 800 bps lower than Wayfair (somewhat apples-to-oranges given private label mix) and consistently called out market share gains.  Given the aforementioned supply chain issues, Wayfair’s business model may actually be exacerbating its challenges.  We believe the quote from Overstock below is in reference to Wayfair’s CastleGate system.  In addition, we are likely experiencing some giveback in market share from online to offline as the world normalizes at least in the short term, which we acknowledge may just be an air pocket and over time we expect e-commerce penetration to continue to grow.

 “Our supply chain is broad and distributed. Our vast partner network reduces single-source risks, shipping bottlenecks and supply chain kinks. In fact, we are proving that our supply chain works well in times of high consumer demand and low supply, partially because suppliers don't want to tie up limited inventory in one or two distribution networks. Unlike some of our competitors, we don't pressure our partners to lock up inventory in our distribution centers. As a result, we tend to get favorable priority on inventory.

Valuation

For much of its history Wayfair has had negative earnings.  As such, we look at historical EV/Sales multiples.   Pre-pandemic these ranged from 0.6x-1.4x.  Currently the stock trades at 1.6x NTM (consensus) sales.   Aside from believing that numbers have to be revised lower, we also expect the narrative and valuation to shift from a growing/scaling e-commerce retailer to one of declining revenue and free cash flow burn.   Indeed, we suspect that this period will represent Wayfair’s first string of negative revenue growth since coming public.   If we were to apply a historically mid-range 1x sales multiple on a modestly revised sales outlook and higher net debt (to account for negative free cash flow) it would suggest that the stock could trade as low as $140-$150 range (-35% lower).   

Summary

Uniquely positioned COVID winner (e-commerce, home furnishings) facing negative mean reversion over the next twelve months.  Gross margin pressure.   Market share losses.  Rising customer acquisition costs (ie. greater marketing intensity).  FCF poised to inflect negative.  Valuation at 30x consensus NTM EBITDA is nothing to sneeze at either.   

Risks

• High short interest (20%), watch out for spikes

• Rising e-commerce penetration

• Sales and/or gross margins prove more resilient limiting valuation compression

• They start accepting Dogecoin as means of payment

Catalyst

- Reported sales & margin weakness

- Deteriorating housing fundamentals