Positioning  

Wayfair aspires to be “the online destination for all things home.” Their strategy is to offer the largest selection of home furnishings with a broad range of styles and price points.  It markets its products with five distinct brands, each targeting a specific niche market ranging from modern design to classic furnishings.

Top line growth accelerated to 52% in 2013, and so far this growth rate has persisted for the six months ended June 30^th, 2014.  Gross margins have been stable and about average at 23-24% of sales. Wayfair is investing heavily in sales and marketing and expects to continue that for some time before ultimately achieving their 8% to 10% long-term operating margin target.

A very basic IV model points to a stock value of $32 which suggests a solid IPO for W this week.

Business Strategy & Market Opportunity

Wayfair believes that consumers typically search for an exclusive “image or feeling” when choosing home decor.  However, it is difficult to achieve this unique look because choices are slim at conventional brick and mortar retailers.   Shoppers searching for distinct items require a large inventory to browse and they need to be able to view many items quickly.  Due to the high cost associated with carrying large inventories, many conventional retailers have a hard time satisfying this demand.  For example, a shopper looking for a bedroom set may have a selection of 20 to choose from at a department store, whereas they will have a selection of 900 bedroom sets at Dwell Studio, which is one of Wayfair’s brands.  In addition, Wayfair offers consumers the ability to more easily mix and match goods from different suppliers.

Not only does Wayfair provide a beneficial service to its customers, it also helps suppliers market their products more effectively.  It offers goods from 7,000 suppliers, many of which would not have access to Wayfair’s 2.1 million customer base without a significant online presence.  They have also designed technology to allow suppliers to provide their full product line quickly and efficiently.  Suppliers rely on analytics generated by Wayfair to determine where current demand and inventory needs are.  In addition to this technology, there is also a direct fulfillment network allowing suppliers to ship goods straight to consumers.  As a result, Wayfair never takes possession of any merchandise.

Market & Competition

Wayfair seeks to differentiate itself from larger e-commerce players such as Amazon by offering a specialized line of furniture, home furnishings, and decor catered towards women, typically 35 to 65 years old, with annual household incomes of $60,000 to $175,000. Some notable direct competitors include Houzz.com and Overstock.com. Because Houzz is not a public company, it is difficult to compare its financial performance to Wayfair.  However, Houzz is growing quickly with 23 million unique monthly users.

We disagree with the neat competitive picture that Wayfair management paints. We agree that there is a high-end segment of the market – served by the likes of Stickley, Thomas Moser, Designs Within Reach, Ethan Allen, and boutiques. However, plenty of customers in the Wayfair demographic shop at Pottery Barn and Crate & Barrel. Not to mention, The Container Store and even Ikea (wearing a hat and sunglasses perhaps).

Fortunately for Wayfair, most of these companies have limited curation, online selection, and delivery options. Amazon has conditioned the market to expect huge selection, good price, and fast delivery. Amazon has failed to grasp retail merchandizing so far. This is why companies like Zuliliy (ZU) have been able to carve out a niche in online consumer retail with a purely merchandising approach.

From a pure online standpoint, we see Overstock as the most direct public competitor today. Although they offer a broad range of products, they have a fairly high proportion of home goods and furnishings versus Amazon, which is heavier in media and electronics.

The real potential competition for Wayfair may come from Home Depot who has a fairly comparable online presence since they own Home Decorators Collection, which started out as a catalog business but now has a very credible online presence at homedecorators.com. So far, Home Depot has not been aggressive in this area. They barely promote their Home Decorators Collection outside of their limited branded design centers. That of course might change when their board looks more closely at how well Wayfair is doing.

Investors might get the wrong idea if they look purely at search results to compare Wayfair with Amazon. A simple search on “table lamp” generates over 11,000 hits on Wayfair, but over 25,000 hits on Amazon. It doesn’t take long to see what’s wrong with Amazon’s results – in the top dozen items returned, 4 of them are not even table lamps. If you’re curious, the others are stick on lights, desk caddy, table, and garbage can. We suspect these were presented because Amazon customers buy these together, but it’s anathema to anyone trying to decorate.

Amazon’s filters are also out of an engineering textbook rather than design – you can filter by manufacturer, material, lampshade size, lampshade material, seller, etc. Contrast that with Wayfair, which offers up filters by style, finish, color, and material. You can also filter by conventional parameters like price, wattage, bulb type, etc. In essence, the experience is very different to suit a very different type of buyer and market.

Management

Wayfair is a Boston-based firm started by Niraj Shah and Steve Conine.  The pair have celebrated a fair amount of success, but not without a few stumbles.  After they graduated from Cornell, they started and subsequently sold Spinners, an IT consulting firm, for $10 million.  However, their second venture, Simplify Mobile, never got off the ground.

They innovated online and created scores of “micro stores” that focused on specific furniture categories like bunk beds, lamps, coffee tables, etc. And the business basically worked, however they soon noticed that a customer might visit one of their specialty sites, buy something, and then never return. For example, bunk beds are something you probably only buy once in your lifetime.

Fortunately for Shah and Conine, they figured it out, raised a large amount of capital from professional investors like T. Rowe Price, Battery Ventures, Great Hill Partners, Spark Capital, and HarbourVest Partners, and consolidated the brands around a single core. In addition, they organized specialty sites focused on specific styles that match consumer characteristics and support repeat purchases. These all leverage the common Wayfair infrastructure.

The founders will be tested anew as the company enters the next phase of growth. They have brought in a strong CFO, in our view, which helps add confidence.

Open Questions

The recent acceleration in growth puts the company in a strong position, but questions remain as to what the sustainable rate of long-term growth will be. There’s quite a bit of room between 20% (historical) and 50% (current) rates.

Customer dynamics are a bit murky and we don’t know what metrics they will report on as a public company. For example, Wayfair shows statistics comparing figures in 2013 versus 2011. Why not the first six months of 2014 versus 2013? So there may be some surprises in store there – direction unknown.

It’s not too late for competition to make it harder for Wayfair to grow. So far, Amazon has failed to discover merchandising. That could change, and they have the resources to do more. Firms like Home Depot and Lowes have aspirations in this space as well.

The Wayfair IPO may also usher in a time of greater M&A activity in this space. We could see companies like Houzz becoming more desirable, the same with properties like Dwell Magazine. We just saw Designs Within Reach acquired by Herman Miller (NASDAQ: MLHR) for about $154M.

Although we have done an IV, it remains to be seen what valuation multiples will persist for companies essentially doing merchandising. For example, the multiple for Designs Within Reach was low – they had approximately $218M in revenue according to the press release. Yet Zulily (ZU) trades at a 4.6x sales.

Conclusion

Wayfair’s success and valuation rely on its capacity to establish itself as the dominant player in the home furnishings category. This will take more than simply “staying the course” and will demand partnerships, strong execution, and effective sales and marketing. The strategic approach has to work, but at the same time bring down expenses in proportion to revenue to give investors visibility on operating profits and returns on invested capital.

This is a solid growth market. Wayfair has $1B of what is a $16B market today that we expect will be $60B (about 20% of purchases) by 2020. Even if they just maintain their market share, they meet our base case long-term growth estimates. They will need to grow their market share to exceed them materially, or the market will need to grow faster than we are forecasting.

Our IV of $32 is conservative in that it assumes a 30% growth rate. If the company can maintain a 40% growth rate, the IV jumps to $47 and at 50% growth, the IV is $67. It might be difficult to expect anything higher than that. Best guess is that $32 is a good target for the IPO to settle, and $47 a decent one year objective.