12 minutes

Wayfair has bold plans to garner market share by building a logistics network, developing technology and expanding globally. But can it turn a profit?

A tick after midnight on April 25, Wayfair Inc. launched Way Day, an ambitious one-day sales holiday it touted in TV, digital and print ads that would feature “the lowest prices of the year” and free shipping on all orders. The event offered discounts on roughly 70,000 of the retailer’s more than 10 million SKUs, with new deals launching every six hours.

In launching a sales holiday, Wayfair was following a path paved by some of the largest e-commerce companies. For instance, Alibaba Group Holding Ltd. in 2009 turned Singles’ Day (Nov. 11) into an online shopping holiday. The event has since grown into a cultural phenomenon that last year grossed more than $25 billion in sales on Alibaba’s marketplaces alone. Similarly, Amazon.com Inc. in 2015 launched Prime Day to celebrate its 20th birthday and to entice consumers to sign up for its Prime loyalty program as the sale’s discounts are only available to Prime members. In its third year in 2017, Amazon’s Prime Day sales were roughly $2.41 billion.

With Way Day, Wayfair was laying down a marker that it’s time had arrived: its aggressive investments to build out a logistics ecosystem, expand internationally and develop customer-facing and back-end technology were coming to fruition. And Wayfair aimed to do so during the prime time when consumers typically shop for home goods, says Liza Lefkowski, the retailer’s head of brand and promotions.

Looking at Wayfair’s comments about Way Day’s top-line numbers, the sale appeared to work. Wayfair posted its biggest-ever day in terms of revenue despite the sale taking place on a random Wednesday in April, says Steve Conine, the retailer’s co-founder and co-chairman. And, in the retailer’s first quarter earnings call, CEO Niraj Shah noted the sale wouldn’t negatively impact the retailer’s second quarter margins.

But the good news didn’t last long. Five days after Way Day, and two days before the retailer reported its first quarter earnings, Wedbush Securities analyst Seth Basham downgraded Wayfair’s stock rating to neutral from outperform. The note accompanying the downgrade highlighted the investment firm’s concerns over some of the very elements that enabled Wayfair to launch its own sales holiday, notably, its aggressive spending on marketing and logistics. The note also highlighted other potential challenges Wayfair could face over an increasingly competitive digital advertising landscape and intensifying competition. Basham’s note helped drive a 13% dip in Wayfair’s share price. And while strong top-line growth in the first quarter helped propel Wayfair’s share price past its pre-downgrade price, the scenario shined a light on concerns shared by many experts about the company’s long-term viability.

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Wayfair grew its e-commerce sales more than 42% last year to $4.64 billion. And, in the first quarter of this year, its sales jumped almost 48%. But it lost $244.6 million last year and $108.1 million in the first quarter alone this year. Those losses stem in part from its aggressive spending to build out a fulfillment network and to develop flashy tools, such as augmented reality features in its app that enable a consumer to visualize how a sofa would look in her living room.

In many ways Wayfair encapsulates the quandary many online retailers face today. With Amazon’s outsized influence casting a shadow across e-commerce, it has become increasingly difficult for retailers to stand out. Wayfair has found ways to garner a sizable share of the online home goods category thanks to marketing campaigns that aim to build brand recognition and its ability to leverage its massive marketing, engineering and technology teams (they totaled 4,659 people at the end of the first quarter, a 46.1% jump from 3,190 people a year earlier) to stay on the cutting-edge of online retail by developing tools such as a visual search feature. But, for now, those costly investments haven’t shown signs that they’ll eventually help the retailer turn a profit, Basham says.

“A year from now, I think Wayfair may well be 30% bigger than it is today,” Basham says. “But it still won’t be profitable. It’s burning cash. It isn’t clear to me that it can stop investing and sustain its top-line growth. That’s its Catch-22.”

It isn’t clear to me that it can stop investing and sustain its top-line growth. That’s its Catch-22.
Seth Basham
Wedbush Securities

In seeking to dominate the home goods category, Wayfair doesn’t have an offline giant to conquer. The category has a diverse array of retailers—from national chains like Crate and Barrel to regional players such as Nebraska Furniture Mart and Harlem Furniture—but no one big box merchant that dominates the space.

“There’s a reason there’s no Home Depot of the home furnishings industry,” says Steve Dennis, founder of the retail consultancy SageBerry Consulting LLC and former senior vice president of strategy, business development and marketing for the Neiman Marcus Group.

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To start, consumers have a wide range of style preferences and often want to see the expensive items they’re purchasing in person, which makes it difficult to merchandise a store. Dennis worked on a team at Neiman Marcus that looked into what it would look like if Neiman Marcus or its sister brand Horchow moved into the furniture business in a more significant way.

“We kept getting caught up on the question of what a home store would look like and what it would carry. It was a very slippery slope to represent the brands we already carried online in our stores. And, on top of that, we couldn’t decide what the store should be. Should it be a sofa store? A home accessories store? Every decision brings with it more questions. It’s not impossible to open a great furniture store with an online component, but no one has really done it.”

That lack of a major national player has been an advantage for Wayfair, says Eric Roth, managing director and head of the consumer retail group at Lazard Middle Market, an investment bank. “Wayfair has taken the approach of selling whatever it can,” he says. In effect, Wayfair and its sister brands—Joss & Main, AllModern, Birch Lane and Perigold—have become the “everything stores” for home goods in much the same way that Amazon and its sister brands have been the “everything store” for just about every type of product consumers buy.

And by operating on a drop-ship model, in which Wayfair’s vendors own the inventory it sells, the retailer can offer a vast assortment of more than 10 million products. When a shopper clicks to view “coat racks,” for instance, she can wade through 7,284 results that range from an $11.99 Richelieu classic brass wall hook to a $1,943.28 Axor freestanding coat rack. And it sells everything from large pieces like sofas and beds to accessories such as wall art, bedding and pillows.

Moreover, consumers generally shop the category by style, which has enabled Wayfair to begin driving consumers to buy its higher-margin private-label brands, which include the traditional Andover Mills, industrial chic Mercury Row and retro-oriented Langley Street. For each of those more than 70 brands, the retailer uses the same drop-ship approach it uses for the other products it sells. It works with suppliers to develop the products, which it then photographs and merchandizes, but it doesn’t own the inventory. Sales of Wayfair’s own branded goods accounted for 57% of Wayfair’s revenue last year, a dramatic increase from 6% just two years earlier.

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Higher-margin house brands are a prime opportunity for growth, Roth says, pointing to the retailer’s recent launch of the Wayfair Sleep mattress brand. “Look at mattress retailers like Casper or Leesa,” Roth says. “They have huge customer acquisition costs. And once they sell a mattress, they don’t have much else to sell consumers. Wayfair on the other hand can sell consumers linens and towels, duvet covers and wall art. If Wayfair can go in and create its own products that have these higher margins, it can goose its margins and drive up the lifetime value of its customers.”

If Roth’s vision of Wayfair’s future materializes, it would help to solve another problem that nearly every home goods retailer faces—consumers don’t buy furniture or other home goods often enough to justify large customer acquisition costs, especially if items have small margins. “Furniture is an infrequent purchase,” Dennis says. “People aren’t in the market that often, which means that even if a brand acquires a customer who loves the brand, she might not return for three, four or five years.”

That’s one major reason some investors are concerned about Wayfair’s marketing spending. There’s probably no better way to understand Wayfair’s spending than to divide its advertising expenses by its number of gross new customers to identify how much it spends to acquire a new customer. The retailer spent $77.40 to acquire each new customer it gained in the first quarter, a 9.2% increase from a year earlier and its highest total since going public.

Conine argues the spending makes sense; despite the retailer accounting for roughly a quarter of what it estimates was $31.6 billion spent online in the home category last year it believes there’s plenty of room for growth.

“There’s a big opportunity ahead of us,” he says. Wayfair had 11.8 million active customers as of the end of the first quarter, which means that only 4.7% of U.S. adults are active customers. “Given that we have the assets to invest and we’re seeing great payment on the ad investment, we see no reason to stop spending.”

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In fact, the number of consumers who are repeat customers of Wayfair is rising. Repeat customers placed 64.3% of total orders in the first quarter compared to 60.4% a year earlier. However, that may not be enough to justify its costs, says Daniel McCarthy, an assistant marketing professor at Emory University’s Goizueta Business School, who recently analyzed Wayfair’s financials in an academic paper with Peter Fader, a marketing professor at the University of Pennsylvania’s Wharton School.

The paper, which compared Wayfair and Overstock.com Inc., sought to offer a corporate valuation model for publicly traded companies. It suggested investors were overvaluing Wayfair (at a $64.16 share price at the end of 2017’s first quarter) by 84.0% and undervaluing Overstock (at a $15.50 share price) by 8.9%.

“The customers Wayfair is acquiring aren’t profitable,” McCarthy says. “Wayfair is spending an enormous amount to acquire them. A company like Overstock is spending significantly less. Even though Overstock isn’t bringing in the revenue that Wayfair is, it’s also spending much less to drive those sales, which is helping it turn a modest profit. Ultimately, everything comes back to profitability.”

That’s a point Overstock executives regularly discuss. “I know it’s not normal convention to talk directly about a competitor, but it’s kind of silly not to talk about Wayfair,” said CEO Patrick Byrne, during the retailer’s fourth quarter earnings call in March, which featured numerous slides comparing the two merchants. “It’s the elephant in the room. It’s changed the whole landscape of the industry we’re in.” While Overstock spent $50 million on advertising in the critical fourth quarter, one slide noted, Wayfair spent $166 million. And, Byrne added, even with Overstock increasing its paid search spending to compensate for a sharp decline in organic traffic, the retailer’s customer acquisition costs were still 31.5% less than Wayfair’s costs.

There’s a big opportunity ahead of us. Given that we have the assets to invest and we’re seeing great payment on the ad investment, we see no reason to stop spending.
Steve Conine
Wayfair co-founder

Wayfair’s aggressive spending has enabled it to take a wide-ranging approach to acquire new customers. The retailer’s customer acquisition tactics have ranged from brand awareness efforts, such as working with TV shows such as the revival of “Trading Spaces” to provide furniture and décor to search and social media ads that are finely tuned to a shopper’s specific actions.

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The retailer has spent several years building out proprietary advertising technology systems that are optimized to Wayfair’s specific needs, Conine says. “Our industry is emotive and style-driven, which means our needs are quite different from many other retailers,” he says. “By taking our technology in house, we can tune it to our specific needs.”

For instance, while a mass market search technology might focus on tailoring keyword bids for everyday items, the approach doesn’t work well for the category because most brand names in home goods aren’t well known and consumers often struggle to describe what they’re looking for. “If you use a packaged ad platform, you’re stuck looking at portfolio bid optimization,” he says. “We figure we can do it better by tuning into the phrasing that matters in the industry.”

That might mean Wayfair knows consumers who search for “red leather bar stool” are typically doing a last-minute price check while someone looking for “brown sectional couch” is typically someone embarking on a living room renovation. Based on data it’s gathered about similar shoppers, Wayfair’s system might bid more aggressively for the consumer who seems to be embarking on a renovation because she’ll likely be a more valuable customer, Conine says.

Beyond that technology, Wayfair also invests in technology that can give it an edge. For instance, last year it launched a new visual site search tool that allows shoppers to search for products with a photo. Consumers can tap the camera icon in the Wayfair search bar on the retailer’s desktop or mobile site or in its app. From there a shopper can take a photo of the product she wants or upload one from her photo storage. Wayfair will then match the image with its products and surface the results. The feature aims to save shoppers time and help them find what they are looking for faster.

Another area Wayfair is aggressively investing in is logistics.

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Delivery is part of the reason there are few nationwide home goods chains, says Paula Rosenblum, a former chief information officer at furniture chain Domain Home Fashions and a managing partner at Retail Systems Research. “Delivery is the part of the business that kills you,” she says.

To avoid losing money on deliveries, retailers need good forecasting to predict the items consumers will want to buy to ensure they’re in stock, as well as delivery density to ensure that a truck has enough deliveries within a small area to make the economics work, she says. That’s particularly true for a merchant like Wayfair that offers free shipping on orders more than $49 (and $4.99 shipping on orders under $49), as well as two-day shipping on “thousands” of items.

Those promises help differentiate Wayfair, says Wedbush’s Basham, before posing the question, “But the question is, ‘Do they justify the cost?’”

The cost stems from the retailer’s effort to build out a logistics, warehouse and delivery network to help reduce the number of steps an item takes before arriving at a consumer’s door. Eliminating steps saves time and helps reduce the costs associated with damaged items, Conine says.

The warehouse network, which Wayfair calls CastleGate, is starting to play a significant role in a number of the retailer’s sales. For instance, roughly 19% of the U.S. sales of small items, such as wall décor and bedding, that Wayfair can ship via a traditional carrier in the critical fourth quarter were shipped from the CastleGate network, up nine percentage points from a year earlier. And around 80% of large parcel orders flowed through the Wayfair Delivery Network, which includes middle- and last-mile delivery networks and facilities.

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Those efforts are helping the retailer save time-consuming steps for shipments. For instance, a traditional drop-ship model might require a small item shipping from a supplier’s warehouse in San Diego to have six to eight touches by UPS and/or FedEx trucks and take up to five days to reach a consumer in New York. With four CastleGate warehouses in the United States (with another set to open this year), one in Canada and one each in the United Kingdom and Germany, Wayfair can use Wayfair-dedicated transportation to fulfill that New York shopper’s order out of its New Jersey warehouse. The truck then will drop the item off at either a UPS or FedEx facility, where the item will occupy one or two vehicles before being delivered.

Larger items are also arriving at shoppers’ doors quicker thanks to Wayfair’s investments. For example, the traditional drop-ship model would use third-party carriers (carrying items from multiple merchants) to take a large item, like a sofa, from a supplier’s warehouse in San Diego. It would then hand off the sofa six to eight times in the span of two or three weeks before arriving at a third-party last-mile delivery company, which would deliver the item to the shopper in New York. For Wayfair, on the other hand, the San Diego supplier ships the sofa to a Wayfair consolidation center and cross-dock where a full truckload of Wayfair items are loaded before being passed to a Wayfair last-mile delivery truck to deliver the sofa to the New York shopper. In smaller markets a third-party company might handle the last-mile delivery.

Between the CastleGate and Wayfair Delivery networks, the retailer is lowering its transportation costs and reducing its damage rate per order, the retailer says. However, the cost of opening the facilities and ramping up their operations is eating into Wayfair’s bottom line, said Michael Fleisher, the retailer’s chief financial officer, during the retailer’s first quarter earnings call.

“We’ve always said on the logistics side that as we roll that out, the costs are actually going to rise a little before they fall back to their original level and then down to lower levels and we’re starting to see that in the operations that have been running for the longest now,” he said. “We’re well into that and we feel extremely good about the trajectory of our delivery cost and the logistics networks we’ve invested in.”

Furniture is a difficult business.
Steve Dennis
Sageberry Consulting

However, Wayfair faces some clear challenges. For instance, there’s Houzz, the home furnishings platform and online marketplace that aims to offer consumers just about everything they might need to embark on a home renovation project. The online marketplace, which was founded in 2009, averages more than 29 million visits a month to its website (that’s roughly in line with Wayfair, which also attracts an average of more than 29 million visitors to its site each month). The home improvement hub offers shoppers more than 10 million SKUs to purchase from 20,000-plus marketplace merchants, as well as millions of home interior images designed to inspire shoppers for their home improvement projects, and a hub where they can contact more than 1 million home professionals, such as contractors, flooring experts and architects.

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And then there’s Amazon, which last November launched two private-label brands of furniture and home goods—Stone & Beam and Rivet. In launching the brands, the retail giant said home furnishings was one of its fastest-growing product categories. And a study from One Click Retail shows Amazon and its marketplace sellers bear out the sizable market Amazon already has. Nearly $7 billion worth of home goods were sold on Amazon to U.S. consumers in 2016, a 33% jump from 2015. That was about 28% of the online home goods and housewares market, and nearly $2.9 billion more than Wayfair sold last year.

That growth stands to continue as Amazon makes it easier for consumers to shop its site for home goods, Basham says. For instance, Amazon revamped its Amazon Home section to help shoppers navigate by style or look. “Amazon has traditionally been a house of brands,” he says. “But this category isn’t highly branded and Amazon now understands that.”

Moreover, Amazon-owned Whole Foods Market Inc. in March launched a beauty, garden and home goods store-within-a-store concept in a handful of locations called Plant & Plate. And many believe Amazon could turn to the surplus of physical storefronts to open showrooms to help middle- and upper-class consumers feel comfortable buying a couch from the same retailer that sells them toilet paper and cat food.

Ultimately though, Wayfair will only succeed if it can turn a profit, Dennis says. That will come if it can boost its margins. The retailer’s margin in the first quarter was 23.4%, slightly less than the 24.0% margin it posted in 2015 and 2016 and the 23.9% it posted last year. That’s several percentage points below its long-term target of 25-27%, which it believes will stem in large part from its logistics investments.

“Furniture is a difficult business,” Dennis says, noting that it isn’t yet clear whether Wayfair is “building a better mousetrap.” What is clear is that at some point it will have to find a cost-effective way catch mice.

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zak@verticalwebmedia.com | @ZakStamborIR