For Wayfair (W), the second quarter was more of the same as the company continued to build out its long-term business model. Wayfair has been one of the rare exceptions in the stock market where headline results do not even matter. While the company posted inline losses on a slight revenue beat, its operating metrics are what investors should be paying close attention to. Despite second quarter operating metrics mostly inline with recent results, Wayfair’s third quarter guidance continues to push the company further away from profitability.
Second Quarter Review
For the second quarter 2019, Wayfair posted a net loss of $182 million, or -$1.35 in EPS. This marginally topped Wall Street estimates which called for a -$1.33 EPS loss. Revenues also came in better than expected at $2.34 billion, or 3.8% above analyst’s average.
While Wayfair’s losses were high in magnitude, the company’s profitability metrics actually improved over the first quarter. As the table below shows, most operating metrics improved sequentially with the minor exception of gross margin falling a tick.
|Q1 2019||Q2 2019|
|Operating Expenses Ratio||17.67%||16.35%|
|Depreciation & Amortization||$39.58||$44.34|
|Depreciation & Amortization Ratio||2.04%||1.89%|
|Adjusted EBITDA Margin||-5.26%||-2.99%|
|Capital Expenditures Ratio||4.39%||3.79%|
|Free Cash Flow||-$166.82||-$91.47|
(Data from Wayfair’s quarterly reports. All dollar figures in millions of USD. Bold Italic percentages show sequential improvements.)
As I noted in my previous Wayfair article, key metrics investors should keep an eye on are costs. Wayfair’s Q2 operating costs of $383.1 million came in almost exactly at my estimate of $384.9 million. For my forward earnings projections to remain intact, costs especially on a percentage basis need to stay below the baseline assumptions made. At least for the second quarter, all the percentage figures in the table above improved. So far, so good.
Third Quarter Guidance And Estimates
Unfortunately, Wayfair’s third quarter guidance suggests deteriorating profitability metrics. From its second quarter conference call, management’s revenue guidance of $2.23-2.28 billion for Q3 suggests a sequential decline from Q2’s $2.34 billion. While we should keep in mind Wayfair typically beats their revenue guidance, this is the first instance of a potential sequential stall in their revenue growth.
Perhaps more important within their revenue guidance is the expectation for their US segment which is expected to grow 30-32% annually. Even at the high end of this guidance, third quarter US revenues would be around $1.927 billion compared to the $1.989 billion posted in the second quarter. As the table below shows, this would be the first sequential third quarter revenue decline for Wayfair since it became a public company.
|Q2 US Direct Revenues||Q3 US Direct Revenues||Q2/Q3 Sequential Growth|
|2019||$1,989.00||$1,927.30 (high guidance)||-3.10%|
(Data from Wayfair’s quarterly reports. All dollar figures in millions of USD.)
It should be very unsettling for investors to see a sequential revenue stall in their most important market. Based on current analyst’s estimates, Wayfair still needs to double its annual revenues before the company is even expected to break-even. Accelerated revenue growth may be the sole reason investors have been able to overlook the company’s extreme losses.
Costs And Margins
One key assumption I made in my previous Wayfair article in evaluating the company’s potential future earnings was that operating costs would not increase beyond fiscal 2019 levels. The table below from that article estimated fiscal 2019 operating costs to hit $1.642 billion.
|Q3 2018||Q4 2018||Q1 2019||Q2 2019 EST||Q3 2019 EST||Q4 2019 EST||FY 2019 EST|
|Operating Expenses Quarterly Growth||11.54%||13.34%||12.80%||12.00%||12.00%||12.00%|
While Q2 operating costs came in almost exactly as I estimated, management’s Q3 guidance implies operating costs will increase even further to an estimated $464 million (explained in the following section). This is 7.7% higher than my previous estimate. Although this does not necessarily break Wayfair’s profitability model, it will push back the company’s break-even date potentially beyond 2022.
A number of key metrics were given by management for the third quarter:
- Capital expenditures will increase from 3.8% of revenues to 4-5% of revenues.
- Stock-based compensation will range between $66-68 million.
- Depreciation and amortization will range between $53-55 million.
- Adjusted EBITDA would range between negative 6 to 6.5%.
Based on this guidance and with the following assumptions below, we can estimate Wayfair’s Q3 operating expenses:
- Gross margin will be 24% which is the average for the first half of 2019.
- Customer Service/Merchant Fees stay level sequentially as a percentage of revenues.
- Advertising expenses stay flat sequentially on an absolute level.
- Revenues come in slightly above the high end of the company’s guidance which has been the trend for the past seven straight quarters.
Q3 Earnings Estimate With Q2 Results Included For Comparison
|Q2 2019||Q3 2019 EST|
|Operating Expenses Ratio||16.35%||20.17%|
|Depreciation & Amortization||$44.34||$54.00|
|Depreciation & Amortization Ratio||1.89%||2.35%|
|Adjusted EBITDA Margin||-2.99%||-5.92%|
|Capital Expenditures Ratio||3.79%||4.48%|
(Data for Q2 taken from Wayfair’s second quarter report. All dollar figures in millions of USD.)
Using the midpoint of the company’s guidance with the exception of above guidance quarterly revenues, we can derive the only unknown which are operating costs that should be approximately $464 million.
The Q3 estimates above also show another key metric increasing beyond my prior assumption cap used in estimating the company’s potential future earnings. Wayfair’s continued increase in capital expenditures to build out its fulfillment business may push depreciation/amortization to 2.35% of revenues, higher than my 2% maximum assumption. Again, this does not break Wayfair’s profitability model but all these incremental cost increases only further pushes back the company’s break-even date.
Wayfair’s stock is currently hovering right above a long-term trendline (purple line) shown in the weekly chart above. However, it is also in a clear down channel (blue lines) since peaking in early 2019. The bearish divergent high in the PMO in early 2019 warned of a possible top. A break below the long-term trendline which currently sits at around $100 could prompt a retest of 2018 lows to around $81 where the 200-week moving average (red line) is currently at.
The daily chart below more clearly shows the current down channel where W hit the upper resistance channel line about three weeks ago at around $135. That price was also where the 200-day moving average was at and represented a good shorting entry after W’s early September rally. W also bounced off its longer-term trendline currently at $100 a few days ago and combined with a slight MACD bullish divergent low could signal a further upside recovery. Should the bounce continue, potential resistance would be at both the downward trending 50-day moving average (green line) and upper band of the recent down channel. Again, should W break below the longer-term trendline at $100, technical selling could take the stock to the low $80s very quickly.
The volume profile chart below also paints a fairly bearish picture. With W clearly below the point of control line (thick red horizontal line) at around $121, the overhead supply resistance should be fairly high. Any rallies towards resistance levels should be met with volume selling.
As I pointed out in my previous Wayfair article, the company’s long-term operating targets even if achieved put profitability several years out. With additional cost metrics worsening given the company’s forward guidance, Wayfair’s break-even date has been pushed back further. Without a clear picture at what level operating costs would peak on an absolute level, it would be impossible to estimate when the company could turn a profit.
In addition, profitability models require extrapolating revenues out several years. There is no guarantee Wayfair could double or triple revenues from current levels. Revenue growth extrapolation was the main fallacy that broke many business models during the dotcom bubble. Management’s forecast of a potential sequential revenue decline in the coming quarter should be a very big red flag. Even back during the euphoria of the dotcom bubble, stocks were punished on any hint of flattening revenue growth. In today’s complacent market, Wayfair’s stock dropped by a mere 1% the day following its guidance forecast.
Other investor concerns should be the company’s free use of capital. Last month, Wayfair concluded its third convertible note offering which grossed $825 million. This increases the total face value of the company’s convertible debt to $1.7 billion which convert at prices between $104 to $148. Should Wayfair’s stock trade below these levels in the next few years due to either cost or revenue concerns, debt would become a very serious concern.
While it may not be a serious issue for some, I find Wayfair’s stock-based compensation to be at ridiculous levels. In Q2 2019, the company’s share-based compensation was 2.4% of revenues and has been guided to increase to 2.9% of revenues in Q3. That is incredibly high for a retailer, and being an online retailer doesn’t make Wayfair a high technology company. In comparison Best Buy (BBY) paid out 0.29% in 2018 while Bed Bath & Beyond’s (BBBY) compensation rate was 0.57% last year. Costs can easily be overlooked during a decade-long economic expansion but should a slowdown or recession take place, the same costs could come back to haunt investors.
Disclosure: I am/we are short W. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.