The -20% move today is a nice near-term win, but let’s be perfectly clear about one thing…this short call is far from over. We saw a few cracks in the foundation within the numbers printed this morning and we think there’s considerably more downside risk embedded in this story as the company continues to invest in an addressable market that is much larger than our research has us convinced it will ever recognize. And ever is a long time.
On the quarter specifically, sales beat by the lowest margin ever at just 0.6% while we saw a slight deceleration in the underlying 2yr rate. Margins came in by 225bps, which equated to adjusted EPS of -$0.43 vs. $-0.15 last year – not exactly going the right direction. The margin on the $295mm in incremental revenue took another step in the wrong direction (after a healthy improvement in 2015) equating to -8% – the worst number we’ve seen in over 18 months.
We can hear the pushback already, specifically centered around the qualitative commentary given to explain the positive trends in the US business and the negative drag associated with the international expansion efforts. Mangement attributed the latter to the delta between break even and -$25mm EBITDA. Meaning the $54mm international business operated at a negative 46% EBITDA margin despite the fact that the company has been in operation in both the UK and Germany since 2008 and 2009, respectively. That sounds like a bit of an over characterization. We’d counter with two points…
1) This is no longer a US story as the company has clearly pushed international expansion up higher in the queue. To date, Wayfair is present in four countries and the management team has now talked to roughly a $180bn market opportunity between the US and Western Europe. What that tells us is the company isn’t done funneling dollars across borders in order to diversify its revenue base. Meaning a bigger drag on earnings for longer.
2) Over the past 12 months, Wayfair has rung the register on $2.7bn in the US. The current market share on Wayfair’s math is 13%, or looked at another way, 4% of its long term TAM. That still leaves a considerable amount of share to be captured in the US if you believe Wayfair’s math. We don’t think the outlook is as opportunistic for W, which based on our work suggests that the company has a $27bn TAM with upside to $45bn vs. the company at $90bn. That tells us that Wayfair is spending up now to supplement an unrecognizable US end market.
The proof of concept exists to some extent in that the company will have added an incremental $2.5bn in sales by the over the course of a 3 year time period by the time the books close on 2016, but what hasn’t been proven is the ability of this model to generate profits. Now the company is looking for new arenas for top-line growth at the same time the company has hit 75% awareness in its core market which accounts for 93% of revenue. Maybe that’s explained away by the fact that 75% awareness has only translated into 10% of the 60mm households (the same number Netflix uses to calculate its US TAM) the company’s uses to gauge its addressable market. From here we think growth continues to be expensive. And, with an 8-10% EBITDA margin target sitting center stage there will be a point in time where the disconnect between the top line trajectory and the earnings power (or lack thereof) will start to matter.
Additional Details On The Quarter…
Does profitability matter? Ultimately, it has to.
The stock took a beating today, and deservedly so given the softer than expected revenue guidance which at the top end landed 5% below Consensus and the margin guide was even worse – nearly 400bps below expectations. But we have to asses what the market really seems to care about as it relates to the stock. 2015 can be characterized as a year with expanding profitability on accelerating revenue which was good for an incremental margin of 3.9%, but 2016 to date has seen a still healthy, though decelerating, top line with accelerating cost evidenced by the -8.5% incremental margin this quarter. We think at some point it has to matter in the conversation, and today was a good indication with the stock giving up all and then some of its gains recognized over the past 9 trading days about on par with where it was 12 months ago.
Repeat Order Double Edged Sword
Driving returning customers is important to the long term success for the Wayfair model as it improves ad spend leverage. Yet the higher the repeat order rate, the worse the implied customer acquisition cost because more repeat customers = fewer new customers, as such ad spend efficacy falls.
Repeat orders also gives us a snapshot of the customer churn rate. The 2Q numbers imply that Wayfair lost about 54% of the active customers it had a year ago. Using Wayfair's own cohort chart indicates that each annual customer group never buys as much as it did when people first bought at Wayfair, which implies significant attrition and/or reduced purchasing for each customer.
Customer/Order Growth:
QoQ customer growth slowed for the second consecutive quarter at 9.8%, the lowest rate in 7 quarters. At the same time orders per active customer bottomed out at sub 2%. Slowing customer acquisition, and fewer orders from those customer, means 2 sides of the revenue triangle are going wrong way for Wayfair.
Ad Efficacy Continues to Weaken
Advertising efficacy weakened for the third quarter in a row, with Revenue dollars per Ad dollars slowing to +4.3%. This is a much more simplistic way to gauge the trajectory of the ad-spend bucket by taking Revenue dollars and dividing by advertising dollars, or how much revenue is driven per dollar of ad spend. After considerable progress in 2015, we’ve seen a meaningful reversal in this metric that is critical to the bull thesis, and faces its toughest compare in 3Q. Though some incremental spend in Europe may be to blame, we’d point to the fact Int’l is just 7% of the business which given its penetration doesn’t explain away all of inflection in trends.
