Summary

Readers may find my previous coverage via this link. My previous rating was a buy, as I believed Wayfair (NYSE:W) valuation was very attractive when compared to peers and that it was on good track for profitable growth. I am reiterating my buy rating as W continues to perform very well, and I expect improvements across revenue growth, gross margin expansion, and EBITDA margin expansion. The significant share gains in the quarter have proven that it has a very competitive position in the industry. As we enter a normalised consumer environment, W should continue to grow at a premium to the industry growth rate. Also, the improving margin profile should warrant a higher valuation multiple.

Financials / Valuation

W reported a solid 3Q23 quarter that beat consensus EBITDA estimates by a big margin. W reported total revenue of $2.94 billion (marginally in line with consensus), but reported adj. EBITDA of $100 million, outperforming consensus estimates of $55 million. Adj EBITDA margin came in at 3.4%, almost double the margin expectation of 1.8%. Strong EBITDA margin performance was supported by sustained high gross margins of 31%, driven by operational cost efficiencies. Other operating metrics also suggest continuing profitable growth momentum ahead. For instance, orders grew 14% and represented a robust sequential acceleration vs. 2Q23 growth of 3%.

Based on my view of the business, I now expect W to grow much stronger in FY24, as I expect W to continue to gain market share, enabling it to grow at a premium to the industry growth rate. The important update to my model is that I now expect W to trade at 1x forward revenue, 1x below its historical average, as I believe its continuous improvement in profitability warrants a higher multiple. When competing against W’s peer (RH), W trades at a steep discount (0.7x vs. 2.6x), and I think the reason for the massive delta is the margins. RH has ~26% margin, while W is still barely profitable on an EBITDA basis. Because of the differences in business models, W will never be able to achieve the same level of margin (RH has a gross margin of 51% while W has a margin of 28%). However, achieving a 10+% adj. EBITDA margin is possible (which is guided by management). I assume a 1x forward revenue by benchmarking W mature adj EBITDA margin profile against RH (26% / 10% = 2.6x diff in multiples).

Coming off our Investor Day in August, we heard many of you asked about the timing of our margin drivers, especially as it pertains to the pathway we described as we journey from a mid-single-digits adjusted EBITDA level to one north of 10%. We broke this pathway down into five components on the slide in our presentation. Source: 3Q23 earnings

Comments

A very excellent quarter for W that reported strong results and has strong indicators that this momentum will continue. Starting from the top, while revenue growth came in at only 3.7%, this growth figure should not be viewed on a standalone basis. 3.7% is actually very strong relative growth when compared to the industry growth rate. Based on management’s assessment, the industry was down mid-to-high teens in the US in 3Q23, while W saw 5% growth in the US. This implies significant share gains for W in the range of 20 to 25%. The implication here is important to note, as this tells me that W continues to have a very strong market position and that consumers are still purchasing furniture from W in this current weak macroclimate. This either means that W has a very strong consumer mindshare or that W products are relatively cheaper than competitors. Either way, it suggests that W strategy is working and is winning share.

From a growth perspective, if W is growing even in one of the worst operating environments, it just shows how much growth potential it has when the economy normalizes. On top of growth normalisation, W also continues to benefit from the continuation of online penetration (this is a secular uptrend). As such, I believe W can continue to grow at a premium relative to the industry growth rate. In the near term, I expect growth to accelerate sequentially, as management noted Way Day 2 performed better than expected but also noted that Black Friday sales are gaining momentum. I believe the promotional periods are going to see elevated traction compared to past years because of the tight spending budget that consumers have today. Consumers are likely to have delayed their spending budget from 3Q to 4Q to take advantage of the deals.

Moving on to margins, I also expect margins to continue improving. With the change in Supplier Advertising revenue and the emphasis on efficiency, gross margins should keep going up. Some investors might be worried that the promotional periods will impact gross margins. I note that the burden of offering discounts is not on W. Remember that W is a marketplace for its suppliers. As such, the discounts we see in the headlines are not all attributable to W. That said, there are instances where we need to step in to invest in price (if suppliers do not want to give discounts during Black Friday, for instance). But I think W has acquired enough financial leeway and capability to invest in pricing when needed while continuing to drive gross margins higher, considering that supplier advertising revenue will increase from 1% in 2023 to 2% by 2025 and that the company is still focused on driving efficiencies. For the near-term outlook, I think management has made it very clear that gross margin is going to continue improving from here. They mentioned on the call that gross margin should keep improving from the 2H23 base, even in a flat sales environment. Over the long term, W also has another catalyst that could drive gross margins higher. Currently, advertising revenues are not accretive to gross profit dollars yet, and management has plans for 2 to 3% of gross margin overtime as this business scales.

We’ve talked about our cost efficiency efforts at length, so I won’t repeat all the details now, but the important piece to remember is that our operative goal is to maximize multi-quarter gross profit dollars.

We largely think of these as independent of core revenue growth as the biggest driver here, supplier advertising, will be achieved through scaling penetration within our existing sales base. Logistics will be driven by further cost savings as we achieved new levels of efficiency in our supply chain in tandem with increased adoption or fulfillment solutions by our suppliers. The remaining 100 basis points to 200 basis points of gross margin potential comes from a combination of merchandising and mix, achieved in large part by expanding the mix of our sales coming from more margin accretive businesses like our higher-end retail brands and our professional platforms. Source: 3Q23 earnings

As for EBITDA margin, my stance is the same as W’s gross margin outlook. The emphasis on driving operational efficiencies by management is commendable and shows in the results. They also clearly laid out what initiatives they were going to drive moving forward. For example, management guided that cost savings on the customer service expense line would continue in 2024. Therefore, I anticipate that the 4.4% exit rate in 2023 will also see an improvement. Regarding advertising costs, management has stated that they will remain in the low teens range, as they have in the past, and that they should de-leverage by 100 to 200 basis points in the long run. If we overlay the gross margin expectation against more cost savings, it points to further EBITDA margin improvement.

Risk & conclusion

In the near term, the risk is that macro headwinds are likely to persist through 1H24. Remember that the industry was down mid-to-high teens in 3Q. While W has grown due to significant share gains, further deterioration in the macroclimate could send the industry into further negative growth territory. W might not be able to gain enough shares to remain in the positive growth territory.

In conclusion, I reiterate my buy rating as W continues to executed really well and has demonstrated its competitive position in the industry, evident from substantial market share gains amidst a challenging macroclimate. I expect sustained revenue growth, gross margin expansion, and EBITDA margin improvement ahead.