Wayfair is nuts, when's the crash?

Monday's jump in Wayfair's share price took the online seller of home furniture to an all-time high of $171.44, 89 per cent above where it started the year.

It's been a maddening run-up for the short-sellers, which include Andrew Left of Citron Research, who slapped a $10 price target on the company in 2015. He returned to the short last summer with a rather higher figure: $100.

Like many battleground stocks of this cycle, Wayfair's $15.5bn enterprise value is a bone of contention for those who believe a company should trade on current fundamentals, rather than Panglossian extrapolations. While it only sells at a relatively modest 2.3 times last year's revenues, according to S&P Capital IQ, the company has yet to make an operating profit, or generate free cash flow, in the last seven financial years.

So has the market just got it wrong?

Maybe not: Wayfair's top-line growth has been startling. In 2018, revenues jumped 44 per cent to $6.8bn, more than ten times what the business made in 2012. This is just the tip of the iceberg: according to an investor presentation from February, the total online market for home furnishings is $600bn.

That would be all well and good if it didn't cost so much to conquer these promised lands. Last year, Wayfair's operating expenses grew 8.5 percentage points faster than sales, causing operating losses to double.

Despite this seeming lack of operating leverage, not all of Wayfair's cash expenditures are accounted for on its profit and loss statement. Deep in the weeds of its 10-K, Wayfair discloses that it capitalises its “site and software development costs”, before amortising the asset over two years. In 2018, this had the effect of reducing operating losses by $63m, all else being equal.

Bulls, perhaps rightly, point to other online retail success stories, such as Amazon, as to why Wayfair's losses are just a marking error in its glorious future. But after six years as a public company, Amazon was generating free cash flow thanks to how quickly it could collect cash from customers, and how long it could wait to pay suppliers.

Although Wayfair benefits from the same arbitrage, it has not been able to repeat the trick as effectively. In 2018 it burnt through $137m of free cash flow, with capital expenditures and software development costs doing the majority of the damage. Clearly building out the distribution infrastructure to compete with Bezos, as well as rivals such as Restoration Hardware and Bed, Bath and Beyond, comes at a cash cost.

Financing these losses hasn't been a problem so far, with the convertible bond market most willing to lend a hand. A five-year convert issued in 2017 raised $431m, while a six-year in 2018 brought in $575m. In February, Wayfair also agreed a $165m revolving credit facility, just in case. Depending on the kindness of strangers has rarely been a good long-term business plan in the frenetic world of capital markets, so converting orders to cash is paramount if the business is to continue succeeding. Particularly with the cycle looking long in the tooth.

However Wayfair's wares of choice — home furniture and furnishings — presents potential problems that seldom apply to other online retailers selling small-ticket commodity products such as batteries, books and bike locks.

Take the nature of the goods themselves. Home furnishings are expensive, one-off items that require deliberation before purchase. (Alphaville itself recently agonised over a bedroom light for months before ordering.) Even then, it's hard to know how an item will tie a room together before it arrives. This theoretically exacerbates the risk of returns and refunds, potentially expensive in the high-cost world of shipping sofas.

Yet this doesn't seem to be an issue at the moment for Wayfair. Its 2018 allowances for returns, a figure “estimated and recorded based on prior returns history, recent trends, and projections” was just $35.7m, a fraction of net revenues.

This may be because Wayfair has taken several steps to counteract the potential for upset customers. Along with the usual bevy of reviews, free swatches and design suggestions, it offers technological wizardry, such as augmented reality, which helps to visualise how a stool will sit at a kitchen table.

All of this amounts to a delighted customer, says Wayfair. And a delighted customer means repeat orders. In Q4 2018, existing customers were 66.4 per cent of orders, up from 62.4 per cent the year before.

Indeed, repeat orders seem to be the focus, with the company stressing to investors the sticky nature of its users, and the benefits that can flow from such a customer.

Wayfair has even outlined its customer acquisition costs versus its revenue per customer, a popular metric for subscription-based companies, such as competitors Amazon and Restoration Hardware (aka RH).

For instance, take this slide from its most recent investor presentation:

The problem here is while Amazon has dependable annual income from its Prime subscribers, and RH from its members program (accounting for churn), Wayfair are assuming that its customers will continue to spend. Somewhat negating the fact that the sunk cost from subscription fees are what draw users back to its competitors, even if the goods are sometimes more expensive.

In the face of less predictable and lumpier revenues, the market seems to think Wayfair's future deserves the loftiest of valuations. Excluding Amazon, Wayfair's 2.3 price-to-sales is higher than all its rivals, including The Home Depot, RH and Bed, Bath and Beyond, according to S&P Capital IQ.

Of this bunch, it also has the second lowest gross margin — just 23.4 per cent — behind pseudo-crypto company Overstock. Even if Wayfair achieves its long term margin goals of 25-27 per cent gross, and 10 per cent (adjusted) ebitda, it would still be percentage points behind most of its non-money losing competitors.

Let's focus on RH's valuation, however, because even if it isn't the perfect point of comparison (due to its mix of online and offline sales), it gives some idea of what Wayfair investors are paying for at the moment.

According to S&P Capital IQ, in the past 12 months RH made $241m of ebitda. With an enterprise value of $4.2bn, this means it trades at a multiple of 17 times.

Reflect the same ebitda multiple figure on to Wayfair, and to justify its valuation, it would need to generate around some $900m of ebitda, given its $15.5bn valuation. As it made an ebitda loss of $404m last year, according to S&P Capital IQ, that implies it would need to save $1.3bn. That may be tough considering last year, Wayfair's entire operating costs came to $2bn.

The alternative, which seems more plausible, is that it can sustainably increase revenues faster than costs, to eventually fill the big valuation boots granted by investors. Problematically though, the company has never managed this feat for successive years since it listed in 2014. It feels like a big bet on the future, with not much hard evidence backing it.

Amazon faced these same criticisms a dozen or so years ago, but early believers were able to fire back with the company's record of cash generation, and later on, the profits of Amazon Web Services. For Wayfair, it is hard to see where the cash may flow from in the short term, particularly as it continues to scale up its own middle and last mile delivery services across the US. In the longer term, of course, lies the looming shadow of growing competition from Amazon, and its big box rivals.

Wayfair's remarkable half decade of 50 per cent growth is nothing to be sneered at. And it may continue for some time yet.

But investors may ask whether a business generating $6.8bn in revenues still needs to be going all in the future, or whether it is time to slow down.

If the economy turns, it may not have much choice.

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