Analysis: Wayfair business model continues to travel in wrong direction
While Wayfair is an expert at driving sales growth, it remains terrible at translating this into profitable gains. Indeed, despite a leap in second-quarter revenue, the company’s net losses grew to a whopping $182 million. Crudely, that means that for every order placed, the company is making a loss of $19.71. In our view, this is far from sustainable and raises questions about the long-term viability of the business.
The main issue for Wayfair is that the underlying dynamics of the business model are not particularly profitable and there are some fundamental truths stacked against it.
First, for a furnishings company its gross margins are low; this quarter they came out at 23.9%, this compares unfavorably to the latest similar numbers from Williams-Sonoma where gross margin was 35.9% and Ethan Allen which posted a 54.8% rate. Much of this has to do with the way in which Wayfair operates, which involves acting as a middle man to provide products from other suppliers and manufacturers – a set up that lacks the margin enhancement of a more integrated operation.
Second, although Wayfair gets a lot of its products from third parties, it increasingly fulfils orders via its own logistics network. In any sector of retail, fulfilment is expensive both in terms of the ongoing operation and the infrastructure investment required to maintain it. However, this is all the more so in home furnishings because of the bulky nature of the product and the challenges that creates for handling. This expense takes a further bite out of profitability and with other retailers ratcheting up pressure on free or low-cost delivery, it is hard to see a near term resolution.
Third, although Wayfair prides itself on its enormous range of products – over 14 million items from around 11,000 suppliers – this does not allow for many economies of scale and adds complexity to the operation. Wayfair has a contention that this extensive selection is a point of differentiation to traditional furnishings retailers. However, while there is some merit in this, we also believe there is merit in more disciplined curation – which is what many consumers are looking for.
Taken together these factors create a business where making money is challenging. Indeed, without marketing expense, Wayfair would make just 3.7 cents for every dollar it sells – in our opinion a very poor rate of return. However, on top of this comes advertising expenditure, which is the Achilles’ heel of the operation.
Since furnishings purchasing is infrequent, some advertising is necessary to remain on the radar of consumers. This is even more so for a brand like Wayfair which has the disadvantage of not operating regular physical stores and which lacks a clear style of design handwriting that drives customers to it. Even so, Wayfair’s advertising costs are out of control – the company spent over a quarter of a billion dollars on advertising in Q2 alone; for the half year, advertising expense has now surpassed the half billion dollar mark. This completely erodes the already wafer-thin margins and pushes the company deep into the red.
Of course, Wayfair could reduce advertising expense. However, if it did it would not grow revenue as quickly and it may find it difficult to activate customers – even those that have shopped with it before. This is the catch-22 situation because of which the prospects for the company look gloomy. The bottom line is that Wayfair is a business model that has not yet proved itself and which continues to travel in the wrong direction.
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