W | Should Be A Lot Lower

Takeaway: Let’s be clear about something…this stock should definitely be a lot lower – but not because of the print.

In going through Wayfair’s 3Q and listening to management on the conference call, one question keeps popping up…”why am I short the stock of a company that is growing its core business over 90% and where 44% of its float is held short?” After all, a) the company crushed sales expectations by 14%, and is now larger than (pseudo-competitor) Restoration Hardware, b) almost every operating metric improved on the margin, c) management clearly has a better handle on its business than ever (and absolutely killed it when someone asked about the NYT article about potential legal liability in its flooring business), and d) management set up 4Q expectations for more top line upside.


At face value, that’s pretty tough to beat.


But then we consider the following…a) Wayfair added $266mm in revenue – an astonishing number. But the company still lost money. True, the operating loss narrowed, but only by $13mm. That pegs the company’s incremental margin at only 5.1%. To be clear, companies like Restoration Hardware and Williams-Sonoma – who are consolidating a different end of the home furnishings market (the good end) have incremental flow-through rates of about 20-25%. Heck, even AMZN, which is not afraid to lose money for a very long period of time, has an incremental margin of 15%. Then why are we looking at 5% for W?


The bottom line is that this company is spending – and it’s spending big – around penetrating what management believes to be the company’s TAM. Unfortunately, we think they are overestimating it by a country mile, and are building an infrastructure for growth that will not materialize – at least profitably. It mentioned 5 times the rate at which it’s hiring (390 people in the quarter vs 225 in 2Q). We’re fine with growing headcount, as long as the opportunity is there. But we don’t think it is.


As we’ve been saying, Wayfair has considerably higher penetration in its TAM than people believe. People – including Management, are using numbers like $90bn as an addressable market. That’s just flat-out wrong. We’ve done extensive research on this one, and when all is said and done, we think that the end market is no more than $30bn. To put that into context, it suggests that Wayfair has about 10% share of its market. That’s 2-3x the share of players like RH and IKEA. There’s absolutely no reason why this should be the case. The primary reason is that Wayfair sells furniture and home goods. The purchasing process for a consumer durable like a set of bunk beds, for example, almost always includes in-store visits as well as online research. You get that at Williams-Sonoma, Restoration Hardware, and even Pier 1. But you can’t touch and feel the seven million items sold by Wayfair before you buy. In fact, our research suggests that W’s target consumer has a ‘blind buy’ threshold of around $750. That’s well below the prices listed for furniture sold on its websites.


To be fair, that only applies to furniture, but what about things like lamps, linens, and kitchen utensils? Yes, that’s where we think Wayfair will drive incremental volume, and management seems to agree. But how defendable is it when that product can also be bought online/in-store at Bed Bath & Beyond, Kohl’s and Target? Overall, our work shows that the incremental customer is likely to be much more price sensitive, which not only challenges long term Gross Margin targets, but takes customer acquisition costs higher off a reprieve in 2015. We do think there’s 500bp upside in Order Margins over time, but we need to see 700bp to get Wayfair in the black.


Could Wayfair manufacture a quarter or two in earnings along the way? Probably. But we have an extremely hard time modeling a sustained operating profit – ever.



Here are some callouts from the quarter...




Top Line Ripping  Revenue accelerated  to +77% from +66% last Q, improving from 56% to 59% on a 2yr basis.  The rapid growth rate has continued in the 4th quarter to date.  Growth was being driven by an increase in both the active customer base, better order metrics, and a higher ticket. Sequential customer growth accelerated to +14% from +12%, LTM orders per customer grew 3% yy, and average order value grew 8% which is the best growth seen in Wayfair's reporting history.  For two quarters in a row now sequential customer growth and percent of repeat customer orders have accelerated, which can be attributed to a lower churn rate.

W | Should Be A Lot Lower - 11 10 W chart1

W | Should Be A Lot Lower - 11 10 W chart2B


Ad Leverage  Even as the company expands its TV advertising campaign W posted massive advertising leverage of 290bps yy to 11.9%.  This paired with accelerating customer growth drove the company's customer acquisition cost down 4% yy.  But, we still need to see 400bps of leverage to get to company's LT target of 6-8% advertising margin. The flywheel is easy to spin when the company is growing its direct revenue base at 90%, but how about when the top line slows to a 20% rate as brand awareness peaks out and market share gets harder to capture?

W | Should Be A Lot Lower - 11 10 W chart3


Rebounding Cohort Spend  W’s updated cohort analysis indicates spending has improved in the last 2 years for old cohorts (2011 & 2012) that had previously appeared to flatline.  This implies the company was either able to re-engage customers which had drifted away from the brand, or that loyal customers have accelerated their spending.  Either way an upward trend on these lines is needed to prove the long term viability of the model since the contrary would mean previous customers and revenue were lost forever.

W | Should Be A Lot Lower - 11 10 W chart4




Wayfair as an everyday store?  That’s how the company justifies its 60mm household addressable market targets. But, let’s be clear about one thing, Wayfair is a Specialty Store that happens to sell 7mm+ SKUs in the home furnishing space. The comparison to a retailer like WMT and TGT is flawed in so many ways, but the most obvious fact is that the average Walmart shopper makes 25+ visits to the store per year, and the average Target shoppers makes 12+ (per our survey data), and that doesn’t count the number of visits/purchases transacted online. The average Wayfair shopper makes only 1.7 orders per year. For a category as event driven as Home Furnishings where the replacement rate is amongst the lowest in retail (especially for the big ticket items) we have a hard time getting comfortable with that logic. If W is going to deliver on its ‘everyday store’ promise it will be in categories like lamps, linens, and kitchen utensils, and that’s not a competitive set that we’d want to be going head to head with.


Brand Awareness and TAM – aided brand awareness by the company’s measure hit 67% during the quarter. That’s up from 55% in 4Q14, 52% in 3Q14, and 36% from 4Q13. Why has the revenue base doubled in 2yrs, look no further than this metric. We can’t argue with the trajectory of the W top line, especially after a quarter in which it reported 91% direct revenue growth. But, now the company will have to prove its mettle in a market that it a) already has 10%+ share of and b) has far less low hanging fruit now that the consumer knows what actually is.


Incremental Margin – Wayfair added an incremental $266mm in revenue during the quarter but only $13mm in operating profit. Need any indication of how much it will cost W to continue to keep the top line spinning? Look at the comparison to RH and OSTK who will/have revenue growth of 14% (estimate) and 11%, respectively in 3Q15. OSTK obviously has a much more mature model than W, but RH is at a similar stage of its growth cycle as it reinvents its store base, and consolidates a fragmented part of the market. The only difference is that RH is putting up industry leading operating margins this year on its way to the mid-to-high teens.

 W | Should Be A Lot Lower - Incrmntl GM   EM

 W | Should Be A Lot Lower - 11 10 W chart6

Green Shoots? 3 Economic Indicators Flashing Red

Earlier this morning on The Macro Show Hedgeye CEO Keith McCullough strung together a laundry list of some concerning economic signals.


Here’s the chart McCullough called up on copper:


Green Shoots? 3 Economic Indicators Flashing Red - copper greenshoot


… And his analysis:


“I can’t for the life of me see how that would be considered a green shoot. Copper is making fresh, new lows after crashing 22% year-to-date. Never mind where it’s come from its all-time bubble peak when Bernanke was devaluing the dollar. That created a bubble in commodities and overcapacity which is creating deflation.


They used to call this [commodity] Dr. Copper. Dr. Copper is signaling that demand worldwide is beginning to slow.”


Another economic indicator McCullough is also watching is the Korean stock market. “But that’s down too,” he says. The Kospi index was off as much as 1.4% last night. “So when we’re looking for red shoots we’re finding them.”


In related news, our Macro team has been concerned about #Deflation risk for a while now.

Green Shoots? 3 Economic Indicators Flashing Red - Deflation cartoon 12.29.2014

The latest deflationary reading comes from China. McCullough addressed this too earlier this morning:   


“[Chinese] producer price deflation remains firmly intact for these producers, with prices down 5.9% year over year. If you’re looking for reasons why Chinese companies have missed earnings and revenue estimates that’s one of the big ones. It’s called deflation and that has not gone away.”


It’s another worrisome data point.


But don’t take our word for it. Here’s Reuters on China, global growth and Apple’s earnings miss today:


“The report on Apple added to fears of a slowdown in global growth, especially in China… China's October inflation data on Tuesday showed persisting, if not intensifying, deflationary pressure.”


Green Shoots? 3 Economic Indicators Flashing Red - appl news


Not good.

Special Guest Contributor View: The Top?

Editor's Note: We are pleased to present this brief Contributor View written yesterday by Doug Cliggott. Mr. Cliggott is a former U.S. equity strategist at Credit Suisse and chief investment strategist at J.P. Morgan. He is currently a lecturer in the Economics Department at UMass Amherst. Incidentally, he recently sat down with us here at Hedgeye for a Real Conversations interview. Click here to watch.


Special Guest Contributor View: The Top? - z doug cliggott


*  *  *

By Doug Cliggott


The OECD released its Economic Outlook this morning and "co-released" their monthly leading indicators with the outlook report.  So the format of the LEI is different this month, but the story remains the same -- US, the OECD as a whole, and China data all continue to weaken. 


The year-on-year decline in the US data is starting to look quite serious.


This data continues to support the contention that peak EPS for the S&P 500 for this cycle is/was a 2015 event -- right now it looks like the $30 operating EPS figure printed for Q2.2015 may have been   


the top ...


Here's the link:

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.43%
  • SHORT SIGNALS 78.34%

McCullough: It’s Looking A Lot Like November 2007


In this brief excerpt of The Macro Show earlier this morning, Hedgeye CEO Keith McCullough discussed “significant decay” in the stock market, lackluster earnings and why it reminds him of 2007. 


Subscribe to The Macro Show today for access to this and all other episodes. 


Subscribe to Hedgeye on YouTube for all of our free video content.

Here's Why McDonald's Still Has 30% Upside | $MCD

Takeaway: Hedgeye's McDonald's call has been spot on. Our analyst says the stock still has significant room to run.

Over the weekend, Barron’s ran a bullish story on McDonald’s (MCD) highlighting the research of Hedgeye Restaurants analyst Howard Penney. He has been extremely vocal about the fast-food company's company’s turnaround. In fact, just prior to the fast-food chain’s breakout earnings release on October 22, Penney wrote that McDonald’s stock “will never trade below $100 again.” 

Here's Why McDonald's Still Has 30% Upside | $MCD - CHART 1 Cartoon


Here are some of the catalysts he highlighted in his recent Fortune piece on McDonald’s, prior to its breakout earnings release on October 22:

  • All Day Breakfast could be a game changer for McDonald’s
  • Management has brought back the value message in its advertising.
  • McDonald’s has a long history of returning value to shareholders.
  • If the company established a REIT it could save billions in taxes.
  • McDonald’s CEO Steve Easterbrook has announced $300 million in cost cutting measures.

It's been a very good call. Shares are currently trading around $113 and are up 19% since Penney's team added the stock to their Best Ideas Long list.


Here's Why McDonald's Still Has 30% Upside | $MCD - mcd chart long


Despite all this, much of Wall Street continues to miss the upside in MCD. As Barron’s writer Vito Racanelli points out in the story:


“Only about a third of the 32 sell-side analysts following the Oak Brook, Ill.-based company rate its stock a Buy. That’s a useful contrarian indicator, but there are other, fundamental reasons to like the stock.”


Here’s another key section from the story:


“Penney says: “Slow growth temporarily, cut costs, and focus on the four walls.” That’s what McDonald’s has been doing since Steve Easterbrook took over as CEO last March, after years of corporate and stock underperformance. Prior to his arrival, the company had added dozens of new menu items and McCafé coffee offerings, increasing complexity in the back of the house and decreasing throughput.


Easterbrook is cutting general and administrative costs, so far to the tune of $300 million, but there’ is more to come, Penney says. McDonald’s will also eliminate about 800 underperforming stores.”


We’ll get more clarity on McDonald’s strategy today (particularly about cost cutting measures and the potential the company will create a REIT), as McDonald's management meets with investors in New York City.


Here's Why McDonald's Still Has 30% Upside | $MCD - mcd analyst day


Bottom line: We added McDonald’s to the long side of Hedgeye’s “Best Ideas List,” in August, when the stock was trading for $99. While the stock is up almost 20% since then, Penney and his team still see 30% upside.


Asia, Copper and the S&P 500

Client Talking Points


Ex-Japan, which loves Burning Yens (Up Dollar), Asian Equities have not enjoyed this Fed hike into a slow-down concept, at all. The Hong Kong Index and the KOSPI are both down -1.4% overnight; India is down -1.6%, and Indonesia is down -1.1% (all of those markets still signaling bearish TREND).


#Deflation Risk is depressing the “reflation” bulls with Copper breaking to new lows down -0.7% this morning at $2.21/lb. Copper’s immediate term risk range is 2.19-2.30.

S&P 500

The S&P 500 is down for 4 straight days and starting to signal moderately oversold in the 2050-2070 zone, so we would cover some green shoot shorts so that we can lay them out again on the next bounce to lower-highs vs. that all-time #bubble high of 2130.


**Watch The Macro Show replay - CLICK HERE

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

Post earnings, the next catalyst for McDonald’s (MCD) is going to be next week's November 10th analyst meeting. The meeting will be an opportunity for management to shed more light on the progress of all day breakfast, additional G&A cuts and the potential of doing a REIT.


Our Restaurants team remains bullish on the name, and they look forward to giving you some material updates after the meeting.


Restoration Hardware (RH) hit all-time highs this week, but this story is far from over. We think RH will earn close to $11 per share in 3 years, which compares to the consensus estimate of just over $6. We estimate that the stock is worth $300.


The square footage component is well known, but we think people are missing…

  1. The productivity and market share that we’re likely to see from each new store,
  2. How scalable this business model is without commensurate capital investment,
  3. The leverage we’re likely to see is below-market real-estate deals being struck today and that should begin to impact the P&L. 

Current policy makers remain fixated on the jobs market, and this Friday’s report was good on the surface. Here’s the rundown:

  • The U.S. added +271K to non-Farm payrolls in October which blew out the expectation for +185K additions (last month’s awful print was revised even lower to +137K additions). Remember that the estimates are useless as the number is near impossible to predict. Keep that in mind.
  • Unemployment Rate moved lower to 5.0% for October from 5.1% in September
  • Wage growth was a positive surprise as Avg. hourly earnings printed a +2.5% growth rate for October vs. an expectation of +2.3%. The growth rate in September was +2.2%

So, again, on the surface it was a positive report. However, as we’ve emphasized, consumption and labor market strength are staples of an economy that is late cycle.

Growth continues to slow, and a rate hike has the potential to pull-forward a recession and flatten the yield curve. In the event this happens, you’ll be happy you held onto your long-bond position. If you haven’t bought into the #slower-for-longer view, the market is giving you the chance to buy bonds at another lower high… For the 5th time this year.

Three for the Road


VIDEO (2mins) The Cyclical + Secular Slowdown Call… via @hedgeye



First say to yourself what you would be; and then do what you have to do.



So far this year U.S. exports are down 11%. The only other times they have fallen this dramatically since the turn of the century were during the last two recessions.

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