You might know Wayfair (NYSE:W) as the e-commerce player that took a category few bothered with online and turned it into a multi-billion dollar growth machine. To some investors, Wayfair has joined the fabled ranks of Amazon-proof (NASDAQ:AMZN) companies.
In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma take their first look at Wayfair -- its origins, track record, competition, and the secret sauce that has allowed the company to thrive while delivering products known to present major logistical challenges.
A full transcript follows the video.
This video was recorded on Aug. 7, 2018.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, August 7th. Joining me via Skype for this discussion is senior Motley Fool contributor, Asit Sharma. Hey, Asit! Welcome back!
Asit Sharma: Hey, Vince! Hello, listeners! I hope everyone's week is proceeding swimmingly.
Shen: Good to have you here! Tell me if you've heard this before. A common question that we get at The Fool, something that comes up a lot in our discussions of various stocks and companies, especially in the consumer retail sector is, "How can companies effectively compete against Amazon?" Does this sound familiar?
Sharma: I actually don't think I've ever heard that question posed in this context, Vince. Yeah, man, all the time, which is why I'm so excited to talk about this company that you have for us today.
Shen: Exactly. This discussion tends to lead to debates over what companies could be considered Amazon-proof. This even includes some of my friends and family who aren't that interested in investing. They'll still ask me about this.
Some examples that we've brought up on the show before and described this way before are: Home Depot, Costco, Tractor Supply Company, Dollar General. For one reason or another, these companies have managed to hold their own, if not thrived, even as Amazon disrupts a lot of other parts of the industry.
Today, we have another candidate for this Amazon-proof club. It's a unique one because it's also focused in e-commerce as an online retailer. It's competing right in Amazon's wheelhouse. The company is Wayfair, ticker W. Many of you have likely made purchases with Wayfair, if not browsed the site or even become a shareholder since the company became a Rule Breaker recommendation in August 2015. What sets Wayfair apart in its e-commerce efforts is its primary product category, and that's furniture and home goods, which has its own set of challenges, in terms of the customer shopping experience, order fulfillment, and more.
The company was founded in 2002 by CEO and co-chairman Niraj Shah and co-chairman Steve Conine. The company was originally founded under the name CSN Stores. Over a decade, CSN Stores became this umbrella of over 200 online stores that specialized in selling specific home goods and household items. Think strollers.com, hotplates.com, cookware.com, all these different sites, a big portfolio of them. The founders eventually decided to consolidate all of these sites into Wayfair for a single, unifying brand. Today, wayfair.com is the biggest part of the business, but it also operates four other sites -- Joss & Main, AllModern, Birch Lane, and Perigold -- to further target specific customers and categories.
At its heart, and a theme that will stretch throughout the show, that makes Wayfair stand out is the approach that it takes to the what, who, and how of its retail model. We'll get to more of that further in the discussion. A question I'd like to start out with for you, Asit, big things that jump out to you for this company? What are some of the highlights?
Sharma: This company is in such an interesting area of e-commerce. The smaller-ticket items were the ones that grew in prominence first, if you look at the evolution of the internet commerce -- consumer electronics, small appliances, etc. One of the hardest nuts to crack is this market for bigger-ticket items -- sofas, dining tables, etc. As you mentioned in your intro, the logistics are very hard to master. You have to move inventory to warehouses, which is known as no mile. For middle mile, you get to the region where the customer lives. Then, you have last mile delivery, and that's yet another difficult part of completing the procedure from the shipper's perspective. The margins don't tend to be very strong.
Amazon has participated in this market for several years now, but it's been dominated up until the 2010s on by companies that listeners are so familiar with, like the Crate & Barrels and Williams-Sonoma's of the world. This online market, which the companies I just mentioned haven't participated in as much, is wide open.
What jumps out at me is, Wayfair, which has been competing in this space for quite a while -- it had its IPO in 2014. 2002 to 2014, that's a really long lifetime in online commerce. They're still growing at a really fast rate. This most recent quarter, which the company just reported on, the company had $1.6 billion in sales. That increased almost 49% year over year. Extremely impressed by that, it certainly piques my interest, given that Amazon last year said it wanted a bigger chunk of this market.
And, I'm interested in the fact that the company has extremely low gross margin, around 23-24%. It's able to operate on a slightly positive basis when you look at adjusted EBITDA -- earnings before interest, taxes, depreciation and amortization. Long-term, the management team has set its gross profit target for right where it is, around 25%. They say that's optimal for the company to flourish.
These things jump out at me. How did a small company manage to grow so quickly, maintain a very consistent form of fast growth and stable margins? I think some of the answer is in the way that it approaches the customer experience on its website. I'll pass it back to you, Vince, with a question for you. I myself browsed Wayfair recently. Listeners, you may remember, last summer we were doing some painting. We've moved on to maybe getting some new furniture. Have you ever shopped on Wayfair or browsed their site?
Shen: Yeah. I was actually checking my email for this. I remember browsing the site in the past, but I couldn't remember if I actually bought anything. I searched my email for Wayfair. 2014, futon mattress purchase was from them. This is a good example of the typical item that a lot of customers will look for. Large parcel, something that presents some challenges, in terms of the logistics of the fulfillment behind that. I remember my experience, in terms of buying that item, getting it, unpacking it, it all went very well.
With this home goods focus, Wayfair values the annual U.S. market at $275 billion. A really big market opportunity. They think that online penetration is around 10%. The market size doubles when you add Europe, where the company has started to expand with younger operations in the U.K. and Germany, the bulk of its business still based in the U.S. Adding those markets effectively doubles the opportunity. In their conference calls, they see this overall revenue potential for home goods at something like $600 billion. A massive market.
With the customers that they focus on, the CFO at an investor conference recently went very specific and defined their target customer as a woman -- 70% of their customers are women -- around 45 years old with a median household income of $80,000. This is somebody who, in terms of their disposable income, has moved on from experiences. They have a family, they have kids, and they really want to create a home that's comfortable for them, a vision of something that brings them joy each day.
The company also speaks to this tailwind of how the aging millennial population, where the oldest millennials have started to enter this phase of their lives where they're starting to buy homes, have families, and enter this demographic that's very attractive for the company. This is also a generation that's extremely comfortable shopping online. The idea of buying a sofa from Wayfair becomes less and less foreign and intimidating. That's a big tailwind, big growth opportunity for the company. It's really interesting. That's on the what side, what they're selling, and who side, in terms of who they're selling to.
The way they sell online, if you think about the typical furniture buying experience, you have to go to many different stores to get different styles, different price points when you're looking at a more brick and mortar-focused shopping experience. Wayfair definitely touts having a really broad selection. This is a really interesting idea -- when you're shopping for furniture or home goods, it's one of the few times when you're buying something where you might not know exactly what you want. I've been helping my wife recently shop for a computer, and we immediately knew, "We're going to go with brands like Lenovo or Dell." We have a very clear vision of what she wants. But, if you're buying bar stools or a sofa or some other furniture, you might not know yet. You're looking for inspiration, in terms of what that interior decor will look like. So, when Wayfair can boast 10 million products, 10,000 suppliers, it really gives them a wide shopping experience that's harder for their typical brick and mortar competitors, whether it's a specialty store or even a big box store like Walmart or Ikea, to necessarily replicate.
That's another really interesting aspect, in terms of what makes the shopping experience with the company more compelling, in addition and on top of the service side of the business, where they're really focused. They have over 2,000 customer service representatives in-house, not outsourced, that are focused on answering questions, helping customers find the right products. All of these things come together to create a pretty compelling experience, in terms of e-commerce, for a less traditional e-commerce product category.
Let's move on into some of the strengths that help them stand out. Everything we've described, you could say Amazon could replicate a lot of that. They're known for pretty good customer service, they have a massive product selection. Something that's a struggle here is the logistics and delivery. Wayfair has invested a lot into that. Can you speak to how the company is creating these competitive strengths through CastleGate and its Wayfair delivery network?
Sharma: One of the problems that we mentioned before, big-ticket items are big. If you want to compete in this business, you essentially have to build warehouses to inventory your products. This company has several thousand suppliers. They range in size from very big concerns to very craft-oriented, small outfits. It speaks to this very large selection that Wayfair offers.
CastleGate is the company's proprietary warehouse system. They call this a forward position supplier inventory complex. That allows the company to deliver smaller parcels in one to two days, larger parcels in about a week plus. The company says that suppliers supply approximately 65% of their inbound volume into their delivery. This speaks more to the fact that the point-to-point delivery is extremely expensive. Wayfair has about four warehouses open in the United States, one in Canada, one in the U.K., and one in Germany. In building up this warehouse capability, that of course decreases some of the company's costs, in addition to serving the customer.
It also has a distribution network that's slightly larger. They call this the Wayfair delivery network. About 9% of the company's large parcel orders flowed through this delivery network in June. So, why is this important? Amazon is famous for utilizing third parties for distribution while it builds up its own capacity. Wayfair is following the same model.
The problem, from a shipping perspective, with large parcels is, you can't fit them on a truckload shipment. The cheapest form of shipping is truckload. If you have 160 widgets that are all the same, you can fit them onto one truck. This is how the logistics industry operates. If you have odd items, items of varying sizes, that will always go to a less-than-truckload shipment, which is more expensive, it's harder to route less than truckload shipment to the various endpoints. So, by creating this distribution network of its own, Wayfair is able to more economically handle what's called the LTL market, which gets the products to that last mile.
As I mentioned before, the last mile is something totally different in and of itself. By the way, Wayfair has invested resources there as well to make sure that when the product comes off the truck, it has its own people taking that off. Not just some third parties, which is going to... and you know, everyone is probably remembering seeing this thing at least once in your life, taking a package, hold the back of the truck and sort of dropping it to the part on to the curve. Part of the investment is making sure that it gets to the front door in a manner which cinches that great customer service from the investment in employees who receive the call questions which have been mentioned to being unpacked. Last thing I want to mention, regarding this end-to-end delivery, is the company has recently partnered with a small start up called Handy, to help unpack the goods that you've ordered, some of them clean up the packaging of the products and leave so you can finally plop down on that couch that you've been ordering and been looking so forward to relaxing on.
Shen: Next up, we're going to talk a little bit about the growth that they're seeing, some of the characteristics of how they acquire customers, their repeat customers. Then, we'll look at some of the risk factors, before we get into the bottom line for this company and the outlook going forward.
Let's move on to our final segment for the show. I wanted to mention some really encouraging figures, what the company considers some of their key performance indicators, in terms of the growth and progress that they're making. For a long time, for Amazon, for example, the market was very forgiving, in terms of its lack of profitability but the incredible growth it showed. Customer loyalty is a big part of that, rapid growth is a big part of that. You spoke to the incredible growth they've recorded in the past year, in the most recent quarter.
Just to give you an idea, most recently, active customers grew 34% for them year over year for the second quarter. They're seeing orders per customer in the trailing 12-month period at about 1.82, averaging out. In terms of the satisfaction that a customer has shopping with Wayfair, it bears out in their repeat customer orders, making up two-thirds of all of their orders. Clearly, people are satisfied enough with the experience to come back to make up two-thirds of those orders and make multiple orders in the trailing 12-month period.
I think there are some very compelling direction there, in terms of what those key performance indicators tell us, in terms of this story. There is also a space where Wayfair occupies this unique niche. We haven't quite seen a bigger company with a lot of resources fully push their weight into the space to compete. I'm curious if there's anything you're looking for that might signal a red flag for you to investors.
Sharma: One of the things that investors should focus on, in terms of risks, is how Wayfair acquires its customers. It's gone more and more heavily into marketing and TV advertising. It also spends quite a bit of money on paid search. According to a recent Forbes article, between 2016 and 2017, if you look at the total paid searches that relate to this home furnishings industry, searches resulting in Wayfair more than doubled, from 6% to 13%. Wayfair held a 13% share in all paid branded searches. But, branded searches where a user inputs the term they want to see -- where Vince types in "Wayfair" so he can get to the site and maybe order another piece of furniture -- that only accounts for 9% of Wayfair traffic.
If you compare that to some well-known retail competitors which have the deep pockets to further their online operations -- Williams-Sonoma, Restoration Hardware are two examples. Those companies are seeing 60-70% brand-modified searches. 60-70% of their traffic is coming from customers who are extremely loyal.
Also in this is this growing customer loyalty statistic that Vince just cited, 1.8 orders in the last trailing 12 months per customer is a huge number when you're talking about items that are as big as a bed or a sofa or a chest of drawers. That's really impressive.
The other key thing to watch, if you look at their investor presentations, is how they're capturing this growing market share. I've seen some estimates that say that online home furnishings is growing at a rate as high as 18% annually. The company itself says that's about a 15% expansion rate. Last year, in 2017, Wayfair's own statistics showed that it took a quarter of all growth in online home furnishings. So, about $4 billion in market expansion. The company snagged $1 billion out of that.
I would watch that statistic going forward to see if it's continuing to grab market share at the same rate. Once Amazon and some of the other companies I mentioned finally get serious about competing with Wayfair, we may see many of these key performance indicators start to sag.
I will ask Vince to weigh in here, I want to return a little bit later to what those risk factors might look like, in terms of a slowdown. My main point is, watch the key performance indicators, watch that market share, how much of it it's grabbing. If you really like to dig into those SEC filings, track the numbers that the company is paying for its paid search.
Shen: Thanks, Asit! Something that investors definitely have to consider, too, here -- I think you spoke to this a little bit earlier, Asit -- is the fact that this is definitely a company where you have to take a longer-term view, in terms of where they are in profitability. The growth is there. We've seen that. But in the most recent quarter, there was a bit of a positive in that their EBITDA for United States was in the black, around $7 million, but still in the red for their international operations as they gain scale. I'm curious what you think in terms of that profitability number, how that changes how people have to look at the valuation, and what your thoughts are.
Sharma: The number is positive from the perspective that the base share of the market right now exists in the United States. Lesser opportunity near-term and a lot of opportunity long-term exists in the U.K., Germany, the rest of Europe, and in Canada. I really like that.
One thing that may affect profitability in the future is if the company has to start competing with Amazon. In 2017, Amazon decided they wanted to get into this market in a bigger way. They've opened a couple of private label stores. You might have heard of brands like Rivet or Stone & Beam. These are new private label furnishings that Amazon is testing. Amazon is very famous for saying, "Your margin is my opportunity." It loves to disrupt businesses and take the margin out. But we should flip that equation for a company like Wayfair. "Your lack of focus and your obsessiveness with winning out margin is our opportunity to curate and build a loyal customer base." That's the flip side of that equation.
One thing I'll say about the valuation, it's really tough right now. The company doesn't have true positive net income. We're always looking at adjusted EBITDA numbers to gauge what cash burn might look like. Valuation is difficult. The company sells at a price to sales ratio of about 1.5X, which is not too overvalued as similar companies go.
I will point out, if you glance at enterprise value to EBITDA -- enterprise value, a short definition is, the total value of the company, all its assets and liabilities, together, and then adding the market capitalization; so, what it's worth out in the real world and the stock market. That ratio, EV to EBITDA, is -50X. That's because when you stop adjusting EBITDA and simply look at EBITDA, the company has lost about $237 million on the last trailing 12 months. I mentioned at the beginning of the show that, with its 25% gross profit, it can stay cash flow positive and slowly, as Vince pointed out, those margins are improving a bit.
I don't think the company is in trouble. But, again, if Amazon really starts to compete, how it will affect Wayfair is, Wayfair will have to go to the markets and either raise money through a debt offering or more stock. If it takes on more debt, that drives interest expense up, which ultimately hurts net income on a GAAP basis, and also gives more of a burden on having to pay debts. If it has to go to the public markets and issue more shares, that dilutes existing shareholders.
Neither one of those is a rosy outcome, but it's what Wayfair might have to do in the future to compete. So far, it's been able to self-fund this growth, which is another thing that makes Wayfair so attractive from an investment standpoint. That's the biggest risk I see going forward. Any risks on your end that you're looking at, Vince?
Shen: I'll close out with, we started this show with this idea of, is this business Amazon-proof? We see here an online-focused retailer, right in Amazon's strongest field of play, and they're still doing incredibly well by specializing and by making the right investments to address what are the biggest pain points for not only the supplier side. The beauty with Wayfair, I don't know if we made this clear earlier, is that they don't carry the inventory. It comes directly from their 10,000 suppliers. They don't have to deal with the headaches of holding that inventory. When they build out this infrastructure, this warehousing and distribution network, it's really focused, OK, maybe these suppliers' most popular products, we store those in our CastleGate warehouses. The big point behind that is so they can get it to customers quickly. Definitely a strength there.
The big question mark, kind of what you mentioned, is that we haven't seen companies, big companies, whether they have a brick and mortar core like Ikea, or the Amazon threat that we bring up so often, really throw their weight into this space yet. $6 billion of revenue for Wayfair, incredible growth, but that's still not at the scale of some of the bigger companies out there, not to mention a company like Walmart or Target deciding that this is a space they want to get into more if they see that it's possible as they build out their own distribution and fulfillment capabilities. That's always a question mark.
But, we have these benchmarks and indicators and different things to follow with the growth of this company that can jump out to us as investors to determine, maybe the profitability needs to come sooner, or, they need to do a better job of holding off the competition. Those are my final thoughts. I'm curious, anything else you'd like to mention, Asit?
Sharma: Just one. I like this stock. I love this Motley Fool recommendation. If you are interested in taking a position, this is a great one to build over a few quarters or a few years. You don't have to buy the whole position you want today, since we've outlined these competitive risks. Just keep your eye on this stock. It may be that, because large-ticket furnishings are so hard to master, as we've said, from a customer service viewpoint, logistics, delivery, maybe no one ultimately really wants to compete that hard with Wayfair. It's a very persuasive investment. You can take your time building a position.
Shen: Alright. Thank you very much, Asit! That's all for us today on Wayfair, Fools. People on the program may own companies discussed on the show, and the Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Asit Sharma has no position in any of the stocks mentioned. Vincent Shen owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and Wayfair. The Motley Fool has the following options: short September 2018 $180 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Costco Wholesale, Home Depot, and Tractor Supply. The Motley Fool has a disclosure policy.