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Morningstar | Wayfair Prints Another Strong Top-Line Quarter Fueled by Increased Spend; Shares Rich

With another quarter of solid sales growth (up 38%, rising to $1.9 billion), no-moat Wayfair continues to capture a rising share of the home furnishing market, handily outpacing the growth across its peer group. However, at Wayfair growth comes at a cost, with the company’s advertising spend up 51% year over year, representing 12.5% of sales (100-basis-point expansion). And while management pointed out that advertising dollars don’t necessarily correspond to the period revenue is generated within, it also noted that the second-quarter advertising ratio was slated to see a year-over-year rise of 75 basis points, to 11.5% of sales, well ahead of its brick-and-mortar peer set (which spend around a mid-single-digit percentage of sales). It’s clear Wayfair sees some benefit to a physical presence as it tests pop-up locations and opens its first store in Natick later this year, and we have long contended the most important benefit for retailers is that they don’t have to continuously remind consumers that the brand exists, alleviating some marketing spend.

We expect that higher spend will persist as Wayfair builds out its infrastructure and adds workers to support these efforts. In the near term, this has led Wayfair to guide to a second-quarter adjusted EBITDA shortfall of around 3.5%, below the 1% shortfall we modeled and marking the worst potential second-quarter EBITDA metric since 2014. We understand the need to spend over the near term to bolster brand awareness, and this doesn’t change our long-term outlook that didn't call for positive adjusted EBITDA metrics until 2021 or positive adjusted EPS until 2023, and which included elevated ad spend (averaging 11.2% of sales through 2023) and an inflated marketing, ops, technology, and G&A ratio (13%). In this vein, we don’t plan any material change to our $88 fair value estimate and view shares as overvalued even after accounting for the significant slide in shares (around 10% in initial trading) on results.

There were a number of positives across first-quarter performance, notably U.S. direct revenue, which increased 39% to $1.6 billion, active customer growth of 39% to 16.4 million, repeat customer growth of 42% to 5.4 million, a rising percentage of orders placed via mobile device, at 53.4%, and gross margin performance of 24.2% above the 23%-24% range the company has set its near-term sights on. Wayfair articulated levers in the gross margin remain, in order to help the company reach its long-term 25%-27% goal, via scale, logistic efficiencies, and rising private-label penetration (that is already above 70%), which our prior model had the company reaching in 2023. But there were some metrics exhibiting slower growth in the quarter, including last 12-month revenue per active customer of $442, which rose 2%, at a slower cadence both sequentially and year-over-year, international growth of 42%, falling from the fourth-quarter pace of 50%, and flat average order value levels.

Higher capital expenditures and operating expenses will pressure profitability in the first half, and the company doesn’t expect “modest” leverage until the end of the year. Capital expenditures of more than 4% in the first half of 2019 is tracking well ahead of 2018’s 3.3% of sales and earlier mentioned advertising and hiring spend should leave little catalysts for near-term cost leverage. The offset here, is that sales growth should still remain robust, with the top line set to capture around a 35% increase in the second quarter, with U.S. direct rising 35%-38%. While this is slower than the 39% the U.S. direct achieved in the first quarter and the more than 40% achieved in 2018, the deceleration in sales have occurred at a slower pace than we initially anticipated, despite Wayfair posting a nearly $7 billion sales base in 2018, well ahead of peers like Williams-Sonoma ($5.7 billion in 2018 sales) and RH ($2.5 billion).