Wayfair Under Attack
The shorts have come out in force on Wayfair (NYSE:W) and their attacks are blistering (PDF). The shares have held up well so far, in part due to sell-side analysts at large firms like BofA/Merrill Lynch who have come out strongly in defense of the company, the business model and the stock. Here is a link to the BAML report (PDF).
Investors may be reminded of the epic battles around Zillow (NASDAQ: Z and ZG), OpenTable (acquired by Priceline) and Zulily (NASDAQ:ZU being acquired by QVC/Liberty Media.) So far the shorts haven't really won in these cases. But others like Angie's List (NASDAQ:ANGI) and Care.com (NASDAQ:CRCM) have worked out well so far.
We wrote a full note on Wayfair around the time of their IPO (see Aspiring to be the Amazon of Home Furnishings) and it's interesting that the stock is now fairly close to our IV estimate (at the time) of $32/share.
How has W performed versus our initial model so far? Revenues are growth faster than we forecast - for example they did $1.3B in 2014 versus our $1.2B estimate and are on track to do about $2B this year versus our $1.56B estimate. Gross margins have also moved up and are nearing the company target of 25-27%. But operating expenses have been higher - in 2014 the loss was $148M versus our estimate of a $94M loss and 2015 is expected to be a little worse than our estimate of a $98M loss.
Do these results or claims from the recent short-seller reports undermine our IV model? In order to answer that we need to dig deeper into the story, the market dynamics and the market opportunity.
Although the short reports are scary they often go too far. For example the one linked above from Citron Research overly relies on a direct comparison between Wayfair and Overstock.com (NASDAQ:OSTK) which oversimplifies things. We do need to expand the discussion to look at the home furnishings market more carefully and also include companies like Zillow, OpenTable, Zulily and Zappos in our consideration for here Wayfair may go from here.
Buying Home Furnishings is Highly Inefficient
It should come as no surprise that IKEA made about 3B on 30B in sales last year (in Euros). Wayfair has stumbled on one approach that is very helpful for consumers - create a huge "virtual catalog" and allow advanced domain-specific search methods. If there is a "special sauce" and/or "moat" for Wayfair this is it. A recent personal purchase might illustrate the power of such a system.
I needed a lighted medicine cabinet for what I refer to as my "barn" but had an existing space for it and some specific desires. I could go to any retailer or Amazon and just get one but that approach didn't allow me to specify the exact dimensions I needed and specifics like sliding doors and overhead lights. With Wayfair I could put that in and find the perfect unit in minutes versus God-only-knows-how-long search and shopping.
To be fair I did actually check around other sites to compare pricing once I discovered the unit that I wanted. Pricing was pretty close elsewhere so I went with Wayfair and it all worked out just fine. This type of capability which I'll called "parameterized search" isn't that difficult to implement but does require domain-specific methods. For example Amazon does this well with things like electronics but not with home furnishings.
When buying home furnishings consumers are interested in design style, materials, colors, finishes, textures, and specific dimensions in addition to cost. The flip side of the "discovery" phase is the linkage to the myriad suppliers of these goods and the ability to get the order processed and shipped. The ability to deliver is a question that has plagued other companies like Zulily and many others into the arms of stronger companies with the infrastructure to satisfy consumer demand.
"Asset Light" or "Un-modeled expenses?"
We love this question which should be raised far more often during the IPO process for companies that "have a great story." The overall target model for Wayfair yields 8-10% EBITDA margins which we'll use as a proxy for operating income. The major lever to get there is advertising which they expect can go from over 12% to 6-8% over time. In order for this to happen customers need to be very happy.
So far not so good based on what we see. While the company cites very good and rising "repeat customer" numbers the information we find is that their internal systems are buggy and prone to being down "multiple times a day." Customer reviews are mixed at best with quite a few terrible ones. Most of the problems stem from delays in delivery, poor packaging and incorrect items being delivered. Low investments in customer service and support have aggravated the problems experienced and tended to create detractors rather than fans of the brand.
The customer problems appear to be stem from a few areas of operations:
- Wayfair relies on third party suppliers and independent delivery vendors. They have no control over the actual fulfillment of the order to the customer. This stands in stark contrast to local home furnishing stores which have their own delivery operation including trucks and staff. There is no question that you get what you ordered and it's delivered on time and with care. It's clear that many Wayfair customers receive their goods late, not at all or get something different than what they ordered.
- Their core technology advantage may be error-prone and fragile. It's partly related to how the company has come together and partly due to rapid growth and high turnover. Technical decisions are made more for speed of fix rather than durability and overall quality of the systems. Furthermore there are "gaps in processes" being created that make reliable, repeatable and efficient workflows difficult.
- Underpaid workers lead to high turnover. Generally workers are happy with the environment at Wayfair but paid below market. This has resulted in very high turnover and may be related to storied customer service gaffs from employees who may not feel they are paid well enough to go the extra mile for an irate customer.
The conclusion is that internal staff, systems and processes are mediocre. Not terrible but not locked down, airtight and ready to scale. Some note that while problems are not very evident today they are getting worse and will bubble over at some point as the systems and processes in place today are not built or updated to deal with what's coming.
What can Wayfair Do?
Anyone interested in this space should take a few moments to read a seminal post by Bonobos founder Andy Dunn on why "Ecommerce is a Bear" because it will put this context. In short some of the methods that can be part of a successful ecommerce business include proprietary pricing, selection, merchandise and experience. Right now I'd say that Wayfair lacks any of these. Here are some ideas though:
- They could take heart though and create private label/proprietary products that are only available on Wayfair. In this case they would also be able to generate higher gross margins if their mix can be driven in this direction.
- Taking ownership of the customer experience is more of a necessity at this point if they ever want to reduce advertising costs. This means investing in infrastructure, systems and staff to differentiate Wayfair versus other online channels. This will mean higher expenses and a revision to their long-term model however.
- Become a real platform for brands. Instead of competing with Amazon take a strategy out of the pages of GSI Commerce (acquired by eBay) and become more of a merchandising solution to other brands. They would own the customer but Wayfair could be the discovery engine and connection point for consumers to do business with brands they haven't used before. This would be a major shift in strategy but might be worth it in the long run given the high margins and multiples this business can fetch if successful.
- M&A is an obvious potential end-point for Wayfair. This is how Zulily solved their challenges with the back end and dealing with real customers at scale. It's a little unclear who the acquirer would be it might be a way for an eBay or other large online retailer to expand their footprint.
Of course the management team can just keep executing and prove their detractors wrong. If they can back off on advertising spend and demonstrate improved customer growth and purchasing patterns then the shorts will be forced to cover. There is probably no way to do it without addressing point 2 of the list above and increasing pay at the company. This would delay their progress toward the target model.
Updating the Model
Our initial post linked above has our model from the time of the IPO which suggested an IV of $32. We're taking some extra time to build out a newer, more detailed version of our typical IV model on Wayfair because it seems like there may be some potential signals in the more detailed numbers.
In the meantime however we've done some tweaking of the numbers (higher revenues and higher expenses) and have decided to change the multiple assumption from 25x to 20x until we become more comfortable with their ability to continue their strong execution without major changes to the model.
The net result is an IV of $23 for 2015 and $29 for 2015. However all bets are if the next few quarters don't deliver improving returns from customer acquisition.
Ultimately Wayfair is not cleary positioned in the market from a consumer perspective. At the high end there is Restoration Hardware to name one company making major investments from a position of having 12-14% margins already (if you back out investments for growth.) At the low end you have IKEA which is just a powerhouse. In the middle you have a myriad of national players like Crate and Barrel, general retailers and local specialists like Bob's Discount Furniture. Online you have Amazon which is enough said there.
When spending a big chunk of money for advertising you want to have 1) clear sustainable positioning and 2) a high long-term profit model (if you don't already have one.) Wayfair has neither right now so the advertising spend is driving results but not create value and wealth for shareholders.
As we wrapped up this chapter of our research on this area it remains clear that this is a fairly big industry that still begs for disruption. Consumers spend thousands of dollars and lots of time on it yet are still faced with two-month delivery times, indifferent service and no efficient search method. This is why rich people hire interior designers who do the legwork, spend time at design centers, wait for deliveries and handle everything for them. This is why so many others flock to IKEA who can supply everything in their own way at low cost. When combined with a service like TaskRabbit you can furnish an entire home with style at low cost with a minimum of time and effort.
At the core consumers don't want "selection" when it comes to home furnishings. They want what fits their needs and to have it done. Designers do it, IKEA does it. Wayfair doesn't really do it.
Remember that this company is well-banked starting with Goldman Sachs. So far these banks are vehement in their defense and support of this company. They also have very strong ability to place Wayfair into a good M&A situation if it comes to that.
Disclosure: Based on this work we decided to short some Wayfair stock and may add to that position on strength and/or clarity that their model is breaking down. Conversely if we measure an improvement in sales and profits combined with large decreases in advertising spend we may close or even reverse our position.
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