Will Wayfair Ever Turn a Profit?

Image source: Wayfair.

Online furniture retailer Wayfair (W -1.94%) has had no problem growing its business. Revenue has surged 59% through the first nine months of this year, and the company expects to generate upwards of $3.3 billion of revenue in 2016. The company's business model, which involves most orders being shipped directly from suppliers, allows Wayfair to hold little inventory. This makes growth far less capital intensive.

While Wayfair doesn't disappoint when it comes to revenue growth, the company is chronically unprofitable. Gross margins are low, typically around 24%, far below its peers. Restoration Hardware, a company currently struggling, still produces gross margins in the mid 30s. Williams-Sonoma enjoys gross margins in the high 30s. And privately held IKEA generated a gross margin of 42.9% last year.

Low gross margin and high operating costs led Wayfair to consistently report substantial losses. Through the first nine months of this year, the company has reported a GAAP net loss of $150 million, more than double its loss during the prior-year period.

With the numbers moving in the wrong direction, will Wayfair ever manage to turn a profit?

Ambitious targets

Wayfair's long-term goal is to bring its gross margin up to 25% to 27% while bringing operating expenses as a percentage of revenue down to 15% to 19%. That would imply an operating margin somewhere between 6% and 12%.

Boosting gross margin by a few percentage points in the long run will likely require greater supply-chain efficiency, something that increased scale could deliver. Even at that level, though, Wayfair will have a leaner gross margin than its competitors.

Bringing operating expenses down will be a bigger challenge. During the third quarter of this year, Wayfair's total operating expenses ate up 27% of revenue, up from 24.1% during the prior-year period. Operating expenses grew by 64.5% year over year, substantially faster than revenue growth of 45%. This relationship will need to eventually reverse for Wayfair to get on the path to profitability.

Advertising is Wayfair's largest category of operating expense, eating up 11.8% of revenue during the quarter. The company's long-term goal is to bring this percentage down to 6%-8%. Advertising accounted for 14.5% of revenue in 2014, so Wayfair is moving in the right direction. But hitting its target range will be tough.

Consider the competition. Amazon, despite its overwhelming dominance and tens of millions of Amazon Prime members, still spends about 5% of revenue on marketing. The biggest uncertainty for Wayfair is whether the company will be able to dial back advertising spending as a percentage of revenue while keeping up its impressive pace of growth.

Other operating costs have been growing. Customer service and merchant fees accounted for 3.9% of revenue during the third quarter, up from 3.5% during the prior-year period. Merchandising, marketing, and sales spending was 4.9% of revenue, up from 4%. And operations, technology, general and administrative spending soared to 6.5% of revenue, up from 4.7%. Long story short: Profitability is taking a back seat to spending aimed at driving growth.

Profits aren't coming anytime soon

Wayfair's asset-light business model allows the company to grow faster with less capital. But it also has a slimmer gross margin than its competitors, and needs to spend heavily on advertising. I'm not convinced that Wayfair will ever reach sustainable profitability, mostly because I have doubts that it will be able to reach its target for advertising spending.

The wildcard is customer loyalty. Advertising spending drives sales, but loyal customers buy things without prompting, and may even spread the word and bring in new customers. Unfortunately for Wayfair, customer loyalty is fickle. The company competes against Amazon, which is the undisputed king of putting the customer first. It will be difficult to rein in advertising costs with Amazon as a direct competitor.

Wayfair has proven to investors that it can grow sales at an incredible pace. But its biggest test will be keeping its costs in check as it becomes larger. I'm not optimistic that Wayfair will be able to hit its targets anytime soon. Investors should expect continued losses for the foreseeable future.