Description

Company Description

Wayfair is one of the largest pureplay ecommerce companies in the world.  With FY’18 estimated revenue of $6.7B, Wayfair is also one of the United States’ largest retailers of furniture and home goods.  Wayfair is headquartered in Boston, MA and today has nearly 11K employees (of which 1,200 were added over the past quarter alone).

The Company was founded by Co-Chairmen Niraj Shah and Steve Conine as CSN Stores in 2002   Originally, the business was a loose collection of product specific websites like barstools.com or birdsnests.com that was clever with SEO and who had lots of drop-shipping relationships with obscure manufacturers.  In 2011, the Company combined inventory across all of their separate websites to create Wayfair.com (https://hbswk.hbs.edu/item/how-wayfair-built-a-furniture-brand-from-scratch).  Around this same time, the two founders accepted venture funding for the first time and in 2014 Wayfair went public.

Today Wayfair generates 85% of its revenue in the US, 9% in Canada, and the remaining 6% in the UK and Germany.  Wayfair defines its target customer as women between the ages of 30-50 with median income of $80,000. Approximately 35% of the Company’s sales are bulky furniture items like couches and armoires that cannot be delivered through traditional one-man parcel delivery networks like USPS, UPS, and FedEx.  The remaining 65% of revenues come from smaller furniture (or self-assembled furniture that can be packed in a small enough box) and home goods / decorative items (pillows, lamps, placemats, ornaments, etc.). Even amongst these smaller packages, Wayfair’s average shipment weighs 30 lbs which is very heavy relative to other e-commerce companies and requires a somewhat different design of their logistics network.

Another important distinction about Wayfair’s product mix relative to other e-commerce companies is the vastness of their SKU count.  With over 10M SKUs, the majority of Wayfair’s sales are drop shipped from their suppliers. The vastness of the SKU count reflects the limited penetration of brands within the categories that Wayfair has chosen to focus on (management gives the example of there being <10 popular brands of paper towels but thousands of lamp manufacturers none of whom the typical consumer has heard of) as well as the typical consumer’s desire for self-expression and individuality in furnishing their home.

Despite the vastness of the SKU count, Wayfair does not take significant inventory from their suppliers unless on consignment.  Remarkably, owned inventory on the Wayfair balance sheet (mostly returns) has only increased from $25M in 2013 to $36M today. Over the same time frame, revenues have increased nearly 5x from $900M to $6.2B.

Another important attribute of the Wayfair business model is their growing reliance on what they refer to as their house brands.  Wayfair has created its 70+ house brands which now account for >60% of revenue (up from 5% in 2015) by selecting individual products from its base of 10K suppliers and rebranding them under names like Corrigan Studios or Varick Gallery to organize their selection based on a common aesthetic and price point.  Rebranding products and including custom photography also makes Wayfair’s product selection appear proprietary and difficult to price compare versus other online retailers (for example, try googling “Curtis Coffee Table Corrigan Studio” versus “Samsung 42 inch TV”)

Premise

After declining by nearly 40% in the past few weeks, Wayfair shares have the opportunity to be a multi-bagger over the next 3-5 years.  At current valuations, Wayfair is trading for similar price / sales valuations as dying brick & mortar retailers with flat (at best) sales growth.  In contrast, Wayfair has the opportunity to grow its sales 35-40% / yr for many years into the future. At the current valuation, Wayfair’s share price can compound in lock step with this rapid pace of sales growth.

Before going into the investment merits, I want to set out two key assumptions that I think anyone needs to believe to come to the above conclusion for Wayfair:

1)     The Wayfair management team is telling the truth when they talk about their decision to lean in on both advertising and opex spending given the high returns on invested capital they are seeing.  If they weren’t seeing such attractive and rigorously quantifiable returns, they would pull back massively on spending rather than chase unprofitable revenue growth and the Company’s income statement would look dramatically better than it does today.  I personally believe that if management was content to grow their business at the same pace as overall category level spending on ecommerce (12-15% / yr) they could run their business today at or above their long-term EBITDA margin target of 8-10%. Part of what gives me confidence in this is my view of Niraj and Steve as very intelligent and aligned capital allocators – the best evidence of which I see in their ability to have bootstrapped Wayfair from scratch to a $6.2B business while still maintaining 35% ownership of the equity.  I’d argue this would be very hard to do if they were spending contribution profit dollars on something other than high return investments. I also think management makes a convincing case on this during the Q&A session of the Q3’18 earnings call

2)     While Amazon will be very successful in penetrating the furniture and home goods market, they will not have >80% online market share in this category.  So long as this proves true, there is more than enough revenue opportunity for Wayfair to build a profitable business that is many multiples the size of what they are today.  There are arguments (many of which I believe) for why Wayfair can provide a considerably better customer experience than Amazon in selling these products and also reasons why the fragmented base of suppliers and vastness of selection and price point in each home sub-category does not lend itself to Amazon’s traditional pricing playbook, but I’d argue this is less important than believing that Wayfair can provide a dramatically better and more cost effective customer experience in selling these products than pretty much anyone else in the industry outside of Amazon (and Ikea for a very specific low end segment)

Investment Merits

If you take my word on these or hopefully come to the same conclusions independently, then its worth considering these reasons why Wayfair has such a long runway for profitable growth and commensurately high equity returns ahead of it

·    Massive TAM moving online

The total addressable market for Wayfair’s product categories is $275B in the US alone and when including Canada and Europe this increases to ~$600B.  Of the $275B domestic TAM, ~12% has migrated online which trails the ecommerce penetration for other retail categories such as apparel (28%) and consumer electronics (34%).  Accordingly, Wayfair has <2% national market share within its categories. But for every $1 of TAM that migrates from brick & mortar to e-commerce Wayfair has taken $0.25-0.30.  If you believe that e-commerce penetration in the home categories where Wayfair has a presence can one day achieve similar levels as where consumer electronics stand today and that Wayfair can maintain a 25% flow share, then Wayfair would be generating $22B in domestic revenues at that point in the future.  While earlier along in their trajectory, Wayfair has an even larger opportunity internationally. If we were to ignore the international opportunity for the time being, at $22B of domestic revenue at some point in the future Wayfair could be generating $2B in free cash flow (and still have <10% market share) versus today’s market capitalization of $8.7B

·    Multiple sources of competitive advantage to sustain outsized market share growth

Wayfair’s heavy investments over the years in delivering the best possible customer experience from end to end give the Company with important competitive advantages relative to other online retailers as well as brick & mortar retailers navigating their transition to omni-channel profitability.  As Wayfair continues to invest back into its business and revenues continue to scale the gap between them and their competitors continues to widen.

Culture and Focus – Wayfair has brought an intensely quantitative approach to a category that has previously been merchandised and marketed based on feel, intuition, and steak dinners.  In addition to having one of the most measurement-focused cultures out of any company I’ve seen, Wayfair has also managed to win over the hearts and minds of countless furniture vendors many of whom have vowed (at least for now) never to sell on Amazon.  This is important because Wayfair is increasingly making in-roads in the upper end of the market where e-commerce competition is next to non-existent and their pricing model has the potential to be highly disruptive considering most of the vendors on their premium tier website www.Perigold.com are typically only sold “to the trade” in design centers.  Across both the high end and mass market, Wayfair’s focus just on the home has allowed it do things that other mass market retailers can’t.  For example, Wayfair has custom built its conveyor belts at its logistics facilities to handle much larger average package sizes than what you’d find in an Amazon fulfillment center.  There are thousands of little things like this which Wayfair has been able to do because they spend 100% of their time focused solely on making the best possible customer experience for the narrow category of home.  Individually none of them are deciding factors, but cumulatively they add up to a combination of lower damage rates, lower returns, higher NPS scores, better product selection, and in turn drive higher customer conversion and repeat rates.  Others can and will copy, but Wayfair should continue to set the pace.

Marketing – A revealing aspect of our research for Wayfair was talking with customer support and sales teams at Google and Facebook.  Both companies view Wayfair as among the top 5 most sophisticated customer acquirers on their platform. This makes sense as Wayfair has developed their own internal ad-tech stack.  Wayfair believes that they’re only matched in this regard by Amazon and Priceline. Importantly, because of the superior selection, usability, and brand perception of the Wayfair website they can drive demonstrably higher conversion to sale rates than other ad-word bidders.  For the same reasons as well as their more comprehensive customer behavior graphs they can more intelligently retarget those customers after their initial purchase which drives a greater propensity to repeat. Together a higher initial conversion to sale and a higher likelihood to return for subsequent purchases affords Wayfair a structurally higher willingness to pay for ad units than their other competitors without sacrificing returns (once again, admittedly Amazon excluded).  I’d argue this is part of the reason why competitors like Williams Sonoma and Overstock complain about what they perceive as Wayfair’s uneconomic spending on advertising. If their web properties were capable of driving similar customer behavior or they were capable of measuring their customer behavior as precisely as Wayfair maybe they’d be able to match Wayfair’s spending. As discussed below, Wayfair maintains a strict 1 year payback period on all of its marketing efforts

Logistics – Aside from rapid headcount growth at headquarters to support new product and technology teams (the vast majority of which management views as discretionary investments that aren’t generating profitability today and which could be curtailed easily if the priority was to maximize near term profitability), Wayfair’s biggest area of domestic investment has been in building out their own logistics network.  Here, Wayfair’s category specific scale has afforded them the opportunity to vertically integrate across the entirety of their supply chain in a way that regional brick & mortar retailers or specialty stores can’t. Wayfair’s two most developed logistics initiatives are Wayfair Delivery Network (WDN) and Castlegate.

WDN is Wayfair’s nationwide system for the delivery of the bulkiest items that can’t be injected into the parcel networks.  WDN takes care of middle mile shipments of furniture from supplier warehouses to Wayfair operated local depots and then orchestrates last mile delivery.  By taking this in house rather than relying on third parties Wayfair believes they can offer faster delivery times, lower costs, and quantifiably better customer satisfaction than others who rely on outsourced service (NPS scores increase 20% in markets where WDN handles last mile delivery).  Today WDN handles Wayfair’s large parcel delivery for 66% (and counting) of the country. In addition to improving customer satisfaction, WDN helps lower costs by reducing damage rates which are notoriously high for cross country shipments of furniture that would otherwise be commingled with other LTL freight whether that’s a lawnmower, chemical barrel, or a piece of industrial machinery.

Castlegate is Wayfair’s inventory consignment program where it partners with the suppliers of its fastest velocity products to store those products in Wayfair operated warehouses closer to the end customer.  The vast majority of Wayfair’s suppliers operate a single warehouse typically on the West Coast nearest to their suppliers in Asia. They lack the scale the to have multiple warehouses across the country. As a result, delivery times to customers tend to be quite long. That’s true even for customers on the West Coast close to these warehouses because the warehouses are not optimized and staffed for to manage single item ecommerce drop shipments (no 24/7 staffing, automated sortation, or downstream parcel injection capabilities).  Castlegate allows these suppliers to store their fastest moving products in a Wayfair warehouse closer to their customer that’s purpose built for ecommerce shipping. In doing so, Wayfair can offer these products with 2-day and increasingly 1-day delivery. This drives an uplift in conversion for participating suppliers which justifies the cost of segregating and consigning the inventory to Wayfair. Castlegate will never be a fit for all of Wayfair’s SKUs, but the percentage of products for which this is a viable win-win option continues to increase as Wayfair scales.  Today >20% of Wayfair revenues are Castlegate products up from ~5% 2 years ago. Castlegate is a classic positive feedback loop that will continually bolster Wayfair’s competitive advantage: the bigger Wayfair gets, the more products that suppliers can justify using Castlegate for. The more products in Castlegate the more products available for faster delivery and the better offering for Wayfair relative to its competition and the more likely Wayfair is to win the incremental customer or repeat order creating a bigger business that makes Castlegate viable for the next supplier and so on and so forth.

·    Misunderstood Unit Economics and Profitability

Bears on Wayfair claim that the Company is not profitably acquiring its customers.  I believe the Company is acquiring its customers at very attractive returns and that those returns are increasing over time as order frequency and gross margins improve.  Management has said that the average newly acquired customer pays back somewhere between their first and second order (which coincides with an average payback period of less than a year because the average active customer completes 1.84 orders per year).  A typical customer will cost $46 to acquire and he will on average spend $450 in his first year. At a 20% contribution margin before marketing less an additional $14 in marketing for repeat orders (7% of revenue), that’s a first year profit per customer of $97.  I think the average customer will spend 30% of that amount in year 2 so $140 in revenue with 20% contribution margins and $9 in repeat marketing for a second-year contribution profit / customer of $18. While the fall off in profitability / customer is steep between Year 1 and Year 2, customer spending beyond Year 2 flattens out or increases slightly creating a stable and profitable annuity stream.  In summary, I think that (all on average) Wayfair spends $46 to acquire a customer, that customer contributes $51 of net profit the year after acquisition ($97 - $46) and $18 every year thereafter. So far with each year that has gone by these economics have improved reflecting improvements in brand perception, customer experience, selection, website design, and sophistication of marketing strategy. If the Company wasn’t able to acquire customers with these returns they would be spending much less than 11.5-12% of sales on advertising.

Valuation and Returns

To illustrate the potential returns on investment in Wayfair let’s assume that the company can grow revenues at a 30% CAGR for the next 5 years and that at the end of the 5 year period they reach 10% EBITDA margins with 1.5% of revenue spent on maintenance capex and a 25% tax rate, then you end up with a business earning $25B of revenue, $2.5B of EBITDA and $1.6B of free cash flow.  At that point Wayfair would have <10% market share (assuming all of that revenue is earned from just the domestic TAM of $275B) suggesting a long runway for future growth. At 15x forward FCF that would suggest a share price of $265 at the end of 2022 which would be a 30% IRR. At 12x forward FCF you’d have $215 / share and a 23% IRR

If you were to use the same assumptions but instead assume only a 20% revenue CAGR then Wayfair would have $17B of revenue, $1.7B of EBITDA and $1.0B of free cash flow.  At 15x forward FCF that would suggest a share price of $180 at the end of 2022 which would be an 18% IRR from today’s price. At 12x forward FCF you’d have $140 / share and an 11% IRR

If you accept the first premise above then I think you can also conclude that investing in Wayfair at the current price offers decent downside protection.  If management were to stop investing for growth and run the business at the mid-point of its long-term EBITDA margin guidance, Wayfair would be generating $500M of EBITDA in the US today.  If they could grow in line with consensus expectations for 1 more year then that would be $650M of EBITDA. With the same maintenance capex and tax assumptions as above, that would imply $310M of steady state FCF this year and $400M of steady state FCF next year.  That equates to a 3.7% FCF yield this year and a 5.0% yield next year without giving any credit to their business in Europe which is growing >50% yoy and has >$1B of revenue

Risks

1)     I’m wrong about Premise 1 or Premise 2 above

2)     Worsening in CAC / LTV trends leads to deceleration in revenue growth

3)     Failure to achieve profitable scale in Europe

4)     Short term margin pressure from furniture tariffs

Catalyst

1)     The income statement starts to show operating leverage in 2019 as the Company’s pace of hiring at headquarters decelerates meaningfully and more contribution dollars become available to absorb investments

2)     Inflection in international revenue growth and profitability as the Company begins to lean in on advertising and build a base of repeat customers in the UK and Germany

3)     Potential to keep revenue growth at or near 40% in FY’19 when consensus is calling for revenue growth closer to 30%.  It is worth noting that while the Company does not manage their business in any way to meet Wall Street expectations (that’s especially true in terms of profitability), Wall Street has consistently underestimated Wayfair’s revenue growth trajectory.  For example, in early 2015 FY’19 consensus expectations were $4.4B and today they are at $8.8B

4)     Longer tail investments in logistics, AR / VR and 3D imaging, and new categories drive an inflection in market share gains