#144 - Wayfair’s Lost Decade

A Drama in Six Charts

Oct 23, 2022

Hi 👋 - Investing is hard. On October 2, 2014, online furniture store Wayfair priced its IPO at $29 per share. On October 14, 2022, shares closed at $28.35, despite years of rapid growth. Below, a look at Wayfair’s lost decade. As always, thanks for reading.

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Show Me The TAM

If you want to build a big business, operating in a large market helps. That’s why companies spend so much time trumpeting their total addressable markets, or TAM.

The US retail market is large and growing. Until very recently, e-commerce has been gobbling up a bigger piece of the pie. According to the US Census Bureau, e-commerce penetration increased to 14% of total retail sales in 2021 compared to 6% in 2014. (Recent declines are more likely post-Covid mean reversion than a change in the secular trend towards increasing online activity.) That’s fertile ground for growing an online business. So far, so good for Wayfair.

Source: US Census Bureau, Monthly Retail Trade – Latest Quarterly E-commerce Report – Q2 2022 Adjusted Sales, August 19, 2022.

Revenue Growth

Since going public in October 2014, Wayfair’s trajectory has been impressive. Revenue has grown from $1.3 billion in 2014 to $12.7 billion in the twelve months ending June 30, 2022, a 35% compound annual growth rate (CAGR), roughly double the growth of the US e-commerce market. Over that span, Wayfair’s customer base grew from 1.2 million to 27.3 million, equivalent to adding the population of Florida. But like anything, look closer, and wrinkles appear. Recently, growth has reversed. In the first half of 2022, revenue dropped roughly 15% versus the prior year as consumers shifted spending from goods like couches and ottomans to services like flights and dining out. (More on that here and here.)

Similar to slipping e-commerce penetration, this is likely a temporary dynamic as consumers stocked up on furniture, a low purchase frequency category, in 2020 and 2021. However, a stock’s price reflects expectations of a business's future performance, and recent trends are clouding Wayfair’s outlook.

Operating Expenses

Revenue growth is a necessary but not sufficient condition to create lasting value. Selling dollar bills for eighty cents leads to quick growth, but isn’t sustainable. Wayfair’s story gets wobbly when you look at expenses. The company’s cost growth has been even more impressive than its revenue growth. That’s not good. In 2014, Wayfair’s operating expenses were 30% of its revenue. For the twelve months ending June 30, 2022 that figure is 31%. Another lost decade.

Looking just at the endpoints misses the nuance. Until 2019, Wayfair generated modest operating leverage (that is, revenue grew faster than operating expense). In 2020, operating expenses fell to 24% of revenue as locked-down shoppers outfitted their homes and customers practically acquired themselves, decreasing advertising intensity. Since then, revenue has declined, while operating expenses growth continues. That’s a pernicious combination, particularly in a market when investors are in a shoot first, ask questions later kind of mood and unprofitable firms are being punished.

Some of this is due to Wayfair expanding capacity during the pandemic and then having the rug pulled out from under it as the world reopened. Some is due to expenses being stickier than revenue; customers may not show up, but employees always do. Like many in e-commerce, Wayfair has recently taken a hard line on expenses. It froze hiring in May and pulled back on strategic projects like European expansion. In August, it laid off 870 employees, 5% of its workforce1. Due to these actions, cost should improve in future quarters.

Adjusted EBITDA

Given that revenue and expenses grew in tandem, it’s not surprising that profitability is puny. While unprofitable, Wayfair isn’t egregious here. Before Covid, adjusted EBITDA margins ranged from (5%) to (1%). They spiked upwards during Covid, as surging demand drove fixed cost leverage and the company could pull back on marketing intensity. With revenue falling, they’ve once again dipped into negative territory for the twelve months ended June 20, 2022.

It’s not black or white whether this is good or bad. Since 2014, Wayfair has been investing heavily in growth. Recent examples are Castle Gate, its global logistics network, international expansion into Germany and the UK (which represent a disproportionate share of overall losses), and a recent love affair with brick-and-mortar retail. These investments could generate high returns. Or not. Similarly, they could be masking improvements in underlying unit economics. Or not. It’s too soon to tell.

What’s clear is that the 2020 and 20201 Covid e-commerce boost shows that the business model is capable of producing operating leverage and profitability. However, 2022 is showing that those operating conditions were temporary. Wayfair is going to need to fight harder for customers when they’re not stuck at home and brick-and-mortar locations aren’t shuttered.

Free Cash Flow

Growing free cash flow per share is what drives long-term value. In contrast to robust revenue and customer growth, Wayfair is anemic here. Free cash flow per share closely resembles adjusted EBITDA, with a spike in 2020 and not much to write home otherwise. There are two main factors at play here. First, investments in capital expenditures equate to roughly 3% of revenue every year. Wayfair has generated positive cash flow operations since 2014 with the exception of 2019 and the twelve months ended June 30, 2022, but capital expenditures pull cash flow negative. Second, the company's share count has slowly, but methodically increased, largely due to employee stock compensation (this is fairly common for tech companies without share repurchase programs). The critical question is what return these capital investments drive over the next few years.

Stock Performance

Despite increasing revenue by an order of magnitude and growing its customer base by more than the population of Florida, Wayfair’s stock closed at $28.35 on Friday, October 14th, below its $29 listing price from 2014. IPO investors would have been better served squirreling money away under their mattresses. (Like comedy, timing is crucial in investing – Wayfair IPO investors who sold in late 2020 made handsome returns.)

To paraphrase Warren Buffett, the stock market is manic depressive. This trait is on full display with Wayfair’s stock. During the second half of 2020 and first half of 2021, it reflected the expectation that the party would never stop. The opposite is true today, as flagging sales weigh on Mr. Market’s spirits.

Wayfair’s lost decade offers a few lessons. First, nailing the macro doesn’t mean you’ll get the micro right. Since 2014, e-commerce has exploded and Wayfair outpaced the market. However, handidly outperforming the e-commerce market didn’t automatically translate into a good investment. This has implications for new technologies like electric vehicles or web3. Second, the benefits of passive investing. Investing is one of the few disciplines that rewards doing nothing. While Wayfair was flat between its IPO and October 14, 2022, the S&P 500 nearly doubled over the same period. For all but the top investors, a passive approach – just owning the market – is often the best one. Third, Wayfair’s story isn’t over. Its ability to navigate current challenges, reign in costs, and generate returns on its investments will dictate the next decade.