Wayfair's Path to Profitability Coming Into Vision, Contingent on Strict Cost Management

Senior Equity Analyst

Jaime M. Katz

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Wayfair plays in the fragmented home goods market across North America and Western Europe (an $800 billion-plus global opportunity), offering more than 40 million products from more than 20,000 suppliers. We think its differentiation comes by way of product breadth and its logistics network, which permits faster delivery with fewer touch points and less product damage than its peers. However, we believe Wayfair lacks brand strength, evidenced by its elevated advertising spending relative to peers and customer acquisition costs. Moreover, we think peers will continue to attempt faster delivery, spurring rising competition. Targeting a wide consumer base of customers 25-54 years old with average household income of $80,000 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 (which we view as merely a function of the marketplace-type model) renders faster inventory turns. This strategy has freed up capital to spend on customer acquisition and retention, leading to 21.8 million active users as of June who spend around $550 per year (versus 1.3 million users who spent $300 in 2021). The pandemic pulled forward the capture of positive free cash flow to the firm to 2020-21, although the metric turned negative again in 2022. However, Wayfair's scale should allow it to return to positive metrics within the next five years as management rightsizes the business to meet evolving consumer demand.

Given Wayfair’s lifecycle position, with significant growth potential but also corresponding expenses to achieve market share gains, we expect returns on invested capital to be volatile. We think Wayfair can hit some of its long-term goals, but the timeline to achievement is trickier. Although it should exceed its prior 25%-27% gross margin target longer term (we forecast more than 30% as Wayfair achieves higher private-label mix and volume and leverages its vendor relationships), we don't see operating expenses in management's targeted range of 15%-19% of sales until beyond 2032.

Business Strategy & Outlook

We don’t believe Wayfair has carved out a durable competitive edge in the highly fragmented and largely commoditized $800 billion North American and Western European home goods markets. With nonexistent switching costs, the global home goods market is intensively competitive; operators compete on price, variety, quality, reliable delivery, fulfillment speed, and associated services. In our view, competitively advantaged home goods retailers tend to develop a moat around intangible assets, benefiting from higher full-price sell-through, and often facilitate consumer stickiness through loyalty programs. Online home goods operators like Wayfair could also exhibit a network effect, given that the value of the distribution network increases with the rise of the consumer and vendor base. However, we believe the intangible asset moat source is often more relevant, since strong network traffic implies brand appeal and drives repeat purchases. While Wayfair’s value proposition is clear to us for both consumers (wide assortment of goods on an easy-to-use platform) and vendors (forward-positioned inventory), its lack of pricing power and limited traces of network effect economics underpin our no-moat rating.

Wayfair connects buyers and sellers (suppliers) through its proprietary online platform, with the benefits accruing to the supplier base, the majority of which are small businesses. Once entering the network, suppliers get immediate access to Wayfair’s 22 million active customers (as of June), insights into product demand by leveraging Wayfair’s technology, and options to enhance product appearance and merchandising through featuring products as sponsored items. In addition, suppliers can economically ship and ensure reliable delivery of products utilizing Wayfair’s robust logistic network, which has been enhanced over the past decade—all the while, vendors are responsible for the cost of inventory warehousing and direct shipping of items. To this effect, Wayfair boasts minimal inventory levels (with turns averaging around 150 times over the past five years versus low-single-digit rates at its peers) and ultimately a faster cash conversation cycle while insulating itself from product obsolescence and unsold inventory risk. Nonetheless, we don’t perceive its faster cash conversion cycle as indicative of a competitive edge; rather, we see it as a function of a marketplace-type model.

As such, we don’t think Wayfair benefits from a network effect, as it’s not apparent whether more buyers and sellers (suppliers) make the company’s ecosystem increasingly valuable to existing and new parties. Customers benefit from more reviews, search results, and improved algorithms as network usage rises. However, there are mixed implications for suppliers, since additional suppliers can lead to higher traffic but also increased competition and potentially lower vendor margins (as Wayfair could garner more negotiating power with increased traffic). Further, we do not believe that Wayfair has demonstrated its ability to successfully monetize its ecosystem. In theory, the cost of customer acquisition should decline over time, assuming the network is strong enough to encourage both parties involved—buyers and sellers—to engage more with the network. However, by our calculations, customer acquisition costs doubled over the past five years to $162 in 2022 from just $80 in 2018 (up 103%), failing to signal that Wayfair has amassed a network effect-sourced moat.

Furthermore, intangible asset advantages often manifest in superior and stable gross margin and/or significant market share, and we don’t believe Wayfair has amassed either. As evidence, Wayfair generates subpar gross margin metrics, despite having meaningful sales (more than half) from its private-label brands. Wayfair’s gross margin averaged 27% over the past five years versus 40% at narrow-moat Williams-Sonoma, 46% at no-moat RH, and 34% at now-bankrupt Bed Bath & Beyond. Furthermore, even with massive cost-cutting initiatives that are expected to accrue $150 million in run-rate savings to the cost of goods sold line by the end of 2023, management expects long-term gross margins that only rise to the mid-30s from 28% in 2022, still well below numerous other operators in the space. Our long-term forecast calls for gross margins averaging around 31%, as we expect intermittent promotional periods to weigh on pricing across what is likely to remain a very fragmented industry.

Wayfair is the largest home goods retailer in the United States, albeit with only a low-single-digit market share. The fragmented nature of the furniture and home goods space offers Wayfair little pricing power. The top four players exhibit a Herfindahl-Hirschman index of less than 15 in the U.S.; an HHI below 1,500 indicates a fragmented market, per the U.S. Department of Justice. We think this signals the lack of competitive edge Wayfair can gain, even with robust spending to build brand awareness, given the cluttered makeup of the category. 

Indeed, Wayfair has been spending almost double the amount on advertising of its peers, averaging 11% of sales over the past five years versus 6% and 4% at Williams-Sonoma and RH, respectively. Though this spending juiced its base of active customers to 22 million in 2022 from 15 million in 2018 and trailing 12-month revenue per active customer to $553 from $443, we see the need to spend more as a signal that Wayfair lacks brand strength and is required to remind customers of its existence through TV, print, and e-commerce media, given its limited physical presence. With a store base composed of just four outlets, Wayfair will continue to spend commensurately more to tout its brand, in our view, while we believe consumers maintain a penchant for comparing products in person when spending on large-ticket items. However, we think efforts here have begun to stall, given that active users retreated nearly to 2019 levels, from more than 31 million active customers in 2020 and 27 million in 2021 to just 22 million in 2022, and customer acquisition costs have remained elevated.

We also think Wayfair’s inability to carve out an intangibles-driven moat is evidenced in its unsuccessful loyalty program foray, which was terminated two years after launch in 2018. This program offered members access to insider sales, discounts for installation and assembly services, and free shipping and next-day delivery with an annual fee of $29.99. In our opinion, consumers have struggled to find value in loyalty programs for lower-priced items, as evidenced by Bed Bath & Beyond’s Beyond Plus membership, which cost $29 and captured just over 1 million customers in the first year of its launch (not meaningful, from our perspective, given the size of the total addressable market). Loyalty programs can offer multiple benefits to retailers—encouraging repeat purchases and unlocking customer insights to enhance marketing efficiency and product resonance—while bolstering sales (loyalty members tend to spend multiples more than nonmembers, to the tune of 2-3 times at wide-moat Lowe’s and Starbucks). Given that successful implementation of loyalty programs in the sector is often dependent on the price of goods sold, this hasn’t impeded Williams-Sonoma and RH from successfully instituting such programs.

Furthermore, while we acknowledge the impressive sales growth (9.3% CAGR) Wayfair has realized over the past decade, we think this has largely been a function of the speed at which the company expanded its supplier base (both its supplier base and top line grew at a 16% CAGR the past five years) and pandemic-fueled demand, rather than increased brand loyalty. We expect the sales cadence to continue to moderate as the business matures, which is reflected in our five-year average sales growth projection of 3%, largely in line with our growth outlook for the industry.

We don’t believe ROICs accurately represent Wayfair’s return cycle, given the magnitude of negative working capital and its generally asset-light model, which has historically led to volatile metrics. Similarly, our ROIC forecast swings widely over the next decade (ranging from negative territory to more than 100%), failing to give us confidence that the firm will be able to consistently generate ROICs above its 9.3% weighted average cost of capital over the next decade.

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.

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