Wayfair (W 3.31%) posted its first profit as a public company in 2020, and management hinted in the 2021 first-quarter earnings report that it's on the verge of reaching sustainable profitability. This is an important milestone for a company that consistently reported net losses through 2019. 

During the earnings call, CEO Niraj Shah said, "While the magnitude of margins will move quarter to quarter and the various tailwinds and headwinds with which we contend will change over time, we are confident that strong profitability will continue and will expand over time as our various investments continue to bear fruit." 

Let's look at Wayfair's business to see why it should be able to further accelerate its profits over the long term.

Two people moving a large sofa outside of a home.

Image source: Getty Images.

Wayfair's platform strategy

In the first quarter, gross margin came in at a healthy 28.8%, up from 24.9% in the year-ago quarter. Over the last four quarters, better margins translated into record free cash flow of $1.5 billion, or a free cash flow margin of 10.1% compared to trailing-12-month revenue.   

The margin for adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) was 5.9% in the first quarter, which is near management's long-term EBITDA margin target of 8% to 10%. 

Wayfair ultimately credits these improving profit metrics to its platform strategy. It combines the attractive economics of an e-commerce marketplace, while offering the benefits of a large online retailer with a vast selection of goods. 

The company carries minimal inventory, which significantly frees up capital to invest in the things that matter to its growth, including expanding its CastleGate shipping facilities and technology that improves the online shopping experience.  

In a way, Wayfair is not a retailer; it is more like a broker between its 16,000 suppliers and 33 million active customers. This provides it with a vast selection of over 22 million products from its supplier network, and Wayfair ships many of these directly to customers -- obviously a money saver right there. 

A lean inventory model, vast selection, and purpose-built website dedicated to helping customers find the right items for their home is creating a profitable flywheel of growth. 

W Free Cash Flow Chart

W Free Cash Flow data by YCharts.

More repeat customers should drive margins up

A key margin booster that investors should pay attention to is the growth in repeat customers. These are more profitable to Wayfair, since it doesn't have to spend as much on marketing expense as it does to bring in a new customer.

Repeat customers accounted for 74.5% of total orders in the first quarter, a significant jump from 69.8% in the year-ago period. This was a record level, which management credited to new customers acquired in 2020 who are now returning to buy more items.

We can already see how growth in repeat customers is coinciding with a steady decline in advertising expense. In 2014, advertising expense made up 14.5% of total revenue when Wayfair had only 3.2 million active customers. In 2020, ad expense dropped to 10%, and management expects this to decline further to the single digits over time. 

A drop of a few percentage points doesn't sound like much, but that amount saves Wayfair about $300 million based on trailing-12-month revenue of $15.3 billion. The company reported over $400 million in net profit over the last year, so a further reduction in ad expense over the next five years could significantly pad growth on the bottom line. 

Wayfair's strategy to sacrifice profit early on in order to build scale is starting to pay off, which should bolster investor confidence in management's execution and long-term vision. The company has a plan to capture a greater share of home goods spending that is shifting online, but with the addressable market estimated at $800 billion, there is potentially decades' worth of growth opportunity. 

Wayfair has proved it can invest in growth while showing a healthy profit, so investors should keep this growth stock on their watch list.