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Mr. Market Is Way Far Off On Wayfair

I've been really intrigued by Wayfair (W) recently.

It started with the purchase of a sleeper sofa last year.

Furniture shopping sucks. Showcase stores are enormous but still have fairly limited inventory, just because of the sheer size of the product. I had a pretty specific idea of what I wanted. The room was painted and carpeted, and was designed around a particular theme that I wanted to fit into. It was also pretty small, so I needed something with very specific dimensions.

To find what I was looking for at a store would have been really difficult and time consuming.

Online seemed like a better option, but I was apprehensive. Amazon doesn't really do furniture very well. Physical store's online presences are a mixed bag. Shipping costs are prohibitive.

This was before I found Wayfair. Wow! Huge selection, detailed descriptions and measurements, plenty of reviews, and... free shipping?! I ordered a sofa, it came 3 days later, fit into the room perfectly. It was a GREAT experience, and I would definitely buy from there again.

So I was curious when I saw the stock show up in the Quality Growth Spell recently. I was even curious-er when I saw the company's revenue growth rates trending at 75-80% year-over-year. And then when I saw the stock carrying just a 1.3 price-to-sales ratio... That seemed quite low to me given the growth and market opportunity.

On the flip side, we've got a vocal short contingent on Wayfair, including well-known short-side outfit Citron Research and hedge fund media personality Whitney Tilson, fresh off his successful short attack on Lumber Liquidators (LL).

So who has a better case, and what is a decent price for Wayfair's stock? Let's review.

The Business

First, let's look at Wayfair's business model.

Wayfair does not own enormous warehouses full of furniture that it ships from. Its business model is more like that of Amazon Marketplace, where 3rd parties use Wayfair's websites as a platform for selling their goods. That lets Wayfair offer over 7 million products (!) from over 7,000 suppliers.

This has 2 advantages. One, it allows Wayfair to boast of easily the largest selection of any furniture retailer - anywhere. And two, since there is no inventory, cash flow is excellent. Even though Wayfair has posted GAAP losses on the earnings front, the company has been free cash flow positive.

This "matchmaker" business model has proven highly successful in the online world. It is a model used by a number of successful companies such as eBay (EBAY), Priceline (PCLN), Alibaba (BABA), Uber, and many others.

In addition to the two advantages listed above, the model also creates a strong network effect. Small home goods retailers want to sell on Wayfair to leverage its investments in technology, brand building, and advertising. Customers want to buy on Wayfair for its massive selection, convenience, and free shipping. This creates a large network that is extremely hard for new competitors to replicate or compete against.

The Bull Case

Clearly I'm a fan of the company's business model. BUT this is a company that is still unprofitable. So what is the bull case?

It is pretty simple, actually. Wayfair is expected to grow sales at over 56% this year, and in Q1 they grew sales at 76% year-over-year. Next year's projected revenue growth is over 35%. It stands to reason that Wayfair should be able to grow sales at 20%+ rates for many years. But for how long?

Online categories

Well, home goods is a HUGE category. In the U.S. alone it is a $100 BILLION dollar market! The size is similar in Europe, where Wayfair has already started to expand. Now consider that only 7% of home furnishing sales are done online, compared to over 15% of apparel and over half of electronics. As this percentage undoubtably grows, so does Wayfair's market opportunity. We are looking at a potential market in the hundreds of billions of dollars here - an enormous opportunity.

Given this, and given the multiple adjacent categories the company might be able to enter, I can't see why Wayfair shouldn't be able to generate $20 billion in sales - or more - within 10-15 years. That is over 8 times what it is doing today.

Then there is the question of margins. Management has targeted long-term EBITDA margins of 7-10%, which is slightly below comparables like Bed Bath and Beyond (BBBY) or Home Depot (HD). I think it is a reasonable target, but even if we come in light at about a 5% expectation, at a mature growth rate that gives us a price/sales target of 0.5 (according to our P/S rules of thumb). Wayfair is far from that. Its current rate is over 50% - nearly 10 times an average rate - so a 2.0 price/sales ratio seems more-than-reasonable. At a 2.0 P/S ratio, Wayfair's stock would be worth $61. That's over 50% of upside from the current quote!

The Bear Case

Citron's well-publicized negative report on Wayfair last August essentially compared the company to Overstock.com (OSTK), saying that once the company tried to build profitability by scaling back marketing costs, revenue growth would collapse. It also looked at the company's customer acquisition costs and determined that Wayfair could never be as profitable as it claimed.

Let's look at the two points.

The Overstock Overstatement

The Overstock.com comparison struck me as kind of bizarre. Sure, Overstock at a glance is similar, essentially acting as a clearing house for partners to sell... overstocked items on.

But that is really where the similarities end. Overstocked items are overstocked for a reason - usually because said items suck. Wayfair is selling the best that its partners have to offer. And if you look at a few metrics, you can see the comparison kind of falls apart:

Metric201220132014 2015TTM
OSTK Revenue1,0991,3041,4971,6581,673
OSTK Gross Margin18.1%19.0%18.6%18.4%18.3%
W Revenue6019161,3192,2502,573
W Gross Margin24.2%24.5%23.6%24.0%24.0%

Overstock's revenue growth has been mediocre, but what is more striking is the absolute values. Starting in 2010 at about 60% of Overstock's revenue, Wayfair has not only overtaken it, but will probably more than DOUBLE it this year. Overstock couldn't maintain robust revenue growth at any kind of reinvestment level... Wayfair clearly can (and is). There is clearly a BIG difference in demand. How can Citron ignore this?

Secondly, the margin profile isn't all that similar. Overstock continually has gross margins under 19%, while Wayfair has margins 500 basis points higher. That's huge in the high revenue, low margin world of big ticket retailing.

Together, these simple metrics illuminate the key difference between the two companies. Wayfair is selling quality items with high demand to a higher income demographic. Overstock is selling leftovers to bargain hunters. Wayfair is displacing Bed Bath and Beyond and Ashley Furniture... Overstock is trying to displace Tuesday Morning (TUES) and Big Lots (BIG). Where do you think the money is?

There is no comparison here. As Jules Winnfield said in Pulp Fiction: "ain't the same (expletive) ballpark, it ain't the same league, it ain't even the same (expletive) sport".

The Customer Acquisition Cost Canard

Another point Citron tried to make is simple enough: it is too expensive for Wayfair to acquire customers and it can never reach 7-10% margins because it has to spend too much to drum up business (I'm paraphrasing here).

At a glance, this seems to have some logic. For 2015, Wayfair's net revenue per customer was $381 (up 11.4%). Gross margin was 24% for the year, and non-advertising operating costs have been about 16% of revenues. This means, on a per-customer basis:

Gross profit: $381 * .24 = $91.44

Net operating profit before advertising: $91.44 - ($381 * .16) = $30.48

Now, Wayfair's most recent disclosure was that it acquires customers for about $64. Uh-oh:

Net operating profit with advertising: $30.48 - $64 = -$33.52

So how IS Wayfair ever going to be profitable? Gross profitability is pretty much what it is going to be. Non-advertising operating cost percentage should be leveraged down as sales grow, but not by enough. With this math, Wayfair's business model does indeed look in trouble.

But these calcs are forgetting one big thing: repeat customers.

With a repeat customer, acquisition costs are very low (often $0). Now the math becomes much different. We don't have to subtract that $64, so each customer is then worth roughly $30.48 per year - about a 8% margin.

And Wayfair has been successful at driving repeat purchases. Most recently, over 55% of orders were from repeat customers, up from just over 53% a year ago. So now we can start to see how the company succeeds over time, assuming it can maintain its current trajectory:

At 0% repeat purchases, profit per customer is -$33.52.
At 25% repeat purchases, profit per customer is (-$33.52 * .75) + ($30.48 * .25) = -$17.52
At 50% repeat purchases, profit per customer is (-$33.52 * .50) + ($30.48 * .50) = $-1.52
At 60% repeat purchases, profit per customer is (-$33.52 * .40) + ($30.48 * .60) = $4.88
At 70% repeat purchases, profit per customer is (-$33.52 * .30) + ($30.48 * .70) = $11.28

What's more, as Wayfair's brand recognition increases, so does word-of-mouth advertising. As revenue increases, so does leverage of both fixed-cost advertising and non-advertising fixed costs. Given these, customer acquisition and operating costs should *fall* over time, substantially, making the above figures conservative. I think 7-10% margins are in the realm of possibility, over time. A 5% "mature" operating margin seems quite feasible.

Now, all of this depends on Wayfair continuing to grow its percentage of repeat purchases going forward. But if it can - and all signs are positive right now - the business model makes sense. And given this, prospective investors should be more than happy with Wayfair's advertising spending right now. The opportunity to capture market share in the greenfield of online home furnishings retail is NOW - the time to sit back and gather in the profits will be later.

Conclusion

Wayfair looks like a very attractive e-commerce play right now. It is growing rapidly. The market opportunity is truly enormous, and the company's market capitalization is puny compared to it. There are few current competitors in the space. Wayfair is building a stronger network effect every day. There are some risks, and certainly if the company is unable to continue growing repeat purchases or if average order sizes start falling, the business model may never generate meaningful profitability. But I'll take that risk given the opportunity. We think Wayfair is worth at least $60, and probably much more than that over the long term.

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