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Closing out their discussion of furniture industry disruptor Wayfair (NYSE: W), the Industry Focus crew covers business risks, things to consider when valuing the loss-prone retailer, and the rationale for investing in “W” shares through gradual purchases.
A full transcript follows the video.
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Vincent Shen: 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.
Asit 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% to 70% brand-modified searches — 60% to 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 (NASDAQ: AMZN) 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.
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 a disclosure policy.