No-Moat Wayfair's Cost-Cutting Initiatives Pave the Road to Improving Profitability 

Senior Equity Analyst

Jaime M. Katz

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Wayfair should be able to support market share growth in the fragmented home goods market when housing spend normalizes, increasing its relevance in the more than $800 billion global opportunity between North America and Europe. Wayfair’s differentiation comes by way of product breadth and its logistics network, which permits faster delivery of both small and large parcels than many of its peers. Faster delivery is a function of fewer touch points, reducing damage and improving Wayfair’s brand equity with each positive delivery experience. However, we think peers will continue to attempt faster delivery, spurring rising competition. Targeting a wide consumer base with a customer age 20-64 years old (200 million domestic households) with income of $25,000-$250,000 also means Wayfair is competing with mass-market retailers, specialty retail, and low-cost providers, making it harder to stay top of mind. This, along with no switching costs, underlies our no-moat rating.

Wayfair's inventory-light model benefits inventory turns, a strategy that has freed up capital to spend on customer acquisition and retention, leading to 21.7 million active users as of March 2023 who spend more than $550 per year (versus 1.3 million users who spent $300 in 2012). This implies its product mix and marketing resonate with end users. The pandemic pulled forward the capture of positive free cash flow to the firm to 2020-21, and scale should allow Wayfair to return to positive metrics again within the next five years, as management actively right sizes the business for evolving consumer demand.

Given Wayfair’s lifecycle position, with significant growth potential but also corresponding expenses to achieve market share gains, we expect ROICs to be volatile. We think Wayfair can hit some of its long-term goals, but the timeline to achievement is trickier. While it should exceed its prior 25%-27% gross margin target longer term (we forecast reaching 30% due to higher private-label mix), we don't see operating expenses in management's targeted range of 15%-19% of sales until 2032. We plan to watch customer acquisition cost trends to determine whether Wayfair could develop a network effect.

Business Strategy & Outlook

We do not believe that Wayfair has established an economic moat, given the limited pricing power of the brand, nonexistent consumer switching costs, and lack of cost advantages. The company competes in a largely commoditized retail category with ample domestic brick-and-mortar and online rivals, and we believe the lack of a moat and the lack of progress toward a moat are conveyed through customer acquisition costs that remained inflated prior to COVID-19 (with costs beginning to flatten in the first quarter of 2023, after rising in 2022). Direct retail advertising spending had also grown in line with sales in the two years prior to the pandemic (with advertising requirement lower in 2020 due to work-from-home demands), an expense that should remain robust. Customer acquisition costs rose to around $90 in 2019 (prior to the COVID-19-related uptick in demand, and versus $66 in 2016), while direct retail advertising spending growth had also increased to support sales increases. Although these costs fell dramatically during the pandemic given the customer's high focus on the home environment as a result of stay-at-home orders, customer acquisition costs have jumped above $100 over the past eight quarters, by our math.

Wayfair continues to outspend versus its peers as a percentage of sales on advertising, confirming that it has to outpace its peers in order to steal share. Over the last five years, Wayfair has spent an average of 11% of sales on advertising, while Williams-Sonoma has averaged 7%, RH 5%, and Bed Bath & Beyond 3% (in their most recently reported fiscal years). We expect this ratio will be 12.3% in 2023, indicating Wayfair will continue to outspend its peer group. The firm consistently spends on perpetual improvement in technology, which elevates selling, operations, general, administrative and technology expenses, but the $1.4 billion costs savings plan underway should allow for modest deleverage over time (as more than half flows through the line item). 

The target market for Wayfair is wide. The company pursues 20- to 64-year-old consumers with annual household incomes of $25,000-$250,000. With the sizable millennial cohort encompassed in the company’s targeted age range, we believe demographic tailwinds exist that will drive further top-line gains. In our opinion, the Wayfair brand is likely to gain some traction, competing for mass-market consumers against companies like Target, Walmart, Bed Bath & Beyond, and others, as we think the Wayfair brand is better perceived than some of its big-box retail counterparts for furniture products. We think taking share in the high-end market with consumers who earn more than $250,000 annually with brands AllModern, Perigold, Birch Lane, and Joss & Main could be a bit more difficult as the willingness to spend on big-ticket products sight unseen could be a bit lower. Wayfair has more recently been targeting growth in the B2B marketplace, which represents a $200 billion total addressable market across the U.S. and Europe.

The company’s spending on building awareness has helped increase sales penetration, expanding the total number of consumers who have purchased from Wayfair. The number of active customers in the direct retail business had risen to 22 million in 2022 from 1.3 million in 2012, printing more than 35% average annual growth through year-end. Last 12-month revenue per active customer also ticked up to more than $550 in December 2022 from $300 in 2012, posting 6% average growth over the last 10 fiscal years. Outlays from Wayfair are helping improve the economics of the business (on a per customer basis) from prior levels, and we expect the network effect to improve as the ecosystem grows. 

As more people use the service with a positive experience, repeat customers have stayed above 75% of the mix starting in mid-2021 from 37% in 2012. Admittedly, this percentage of repeat users could be larger due to the consumer base shrinking in recent periods, implying new customers have been harder to come by. We believe the stickiness of these consumers is helped by the company’s access to more than 20,000 suppliers and 40 million products, offering the endless aisle to consumers who might be looking for something specific.

While the brand intangible asset would traditionally be the obvious place the company could garner a moat longer term, we believe the supply chain and underlying cost structure are differentiating factors for this company. Wayfair is focused on an inventory-light model, neither designing nor carrying the inventory that it sells (including private-label brands where Wayfair puts supplier products into one of its more than 100 in-house brands, and which reached more than 72% of U.S. revenue in 2021, the last period reported). For example, Wayfair sold $12 billion in merchandise and carried $90 million in inventory on its balance sheet at year-end (2022). Products are shipped to customers directly from suppliers or through the CastleGate fulfillment network. This has led to inventory turns that have handily lapped peer set inventory turns (Bed Bath, Williams-Sonoma, RH, Pier 1, Ethan Allen), which averaged a low-single-digit rate in their most recent fiscal years. For Wayfair, inventory turns escalated from around 60 times in 2013 to around 100 times in 2022.

The robust distribution network Wayfair has built out, with more than 90% of large parcel shipments routed through the Wayfair middle mile and more than 40 Wayfair-controlled last-mile facilities operating, covers about 75% of Wayfair's U.S. and nearly half of Canadian large parcel home deliveries. While the last mile tends to be the most expensive, the Wayfair process reduces the number of touches between order and delivery, decreasing delivery time and reducing damage risk offsetting other potential expenses. Although Wayfair may be a bit faster on deliveries at the current time, we expect this is an effort all competitors are focused on, going head to head with Amazon for speed to end user, and we don’t think Wayfair will be differentiated by the shortened delivery times it can currently offer over the long term. 

While our model shows adjusted returns on invested capital that are widely volatile relative to our 9.4% cost of capital assumption, we believe this is a function of the asset-light model and the working capital structure. We expect this metric will normalize as the company’s penetration reaches critical mass and top-line growth begins to slow from a startup cadence, while the increasing magnitude of negative working capital skews the metric, making it less relevant than for other home furnishing retailers.

We don’t think the company has enough of a competitive advantage in its brand intangible asset, cost structure, or network to warrant a narrow or wide moat. With few barriers to entry, we believe online retailing is a relatively unprotected operating space. As industry behemoths like Amazon continue to invest in strategic categories, including furniture and home furnishings, pricing is likely to remain promotional--and while this might not be by way of sale or clearance merchandise, it may be by sweeteners to facilitate the transaction (for example, a certain dollar amount off the next purchase). We don’t believe that customer loyalty is ultimately aided by a no-fee credit card or loyalty but that awareness is increased and there is a natural introduction to consumers who may not be prior Wayfair customers, an activity that nearly all competitors are undertaking as well. 

We do think Wayfair has a unique business model that allows vendors to deliver inventory faster to consumers with the CastleGate network, but again, we think competing against Amazon as well as other peers that are attempting to speed up delivery times (Williams-Sonoma, RH) puts this competitive edge at risk. There is a brick-and-mortar expansion underway, which could increase visibility making the brand more relevant in certain circumstances. Given the competitive nature of the industry and the lack of pricing power, we don’t believe Wayfair has an economic moat.

None

Economic Moat

Wayfair

Wayfair, Inc. engages in an online home furnishing store. It operates through the U.S. and International segments. The U.S. segment consists of amounts earned through product sales through the company's five distinct sites in the U.S. and through websites operated by third parties in the U.S. The International segment is composed of earnings through product sales in international sites. The company was founded by Steven K. Conine and Niraj S. Shah in May 2002 and is headquartered in Boston, MA.

Earnings data Q2 2023

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