Wayfair And The 24% Risk Of 2-Year Default (NYSE:W)

Even though Wayfair (W) posted a strong prior quarter due to the transition to e-commerce and also its first quarterly profit in years, it’s tacked with an 18.6% chance of one-year default and a 24% chance of two-year default per S&P Global with an implied rating of CCC, putting it on spot 8 of the top 15 most vulnerable retailers. And although Wayfair’s growth has been recognizable and turbocharged during the pandemic, the sustainability of that growth is inherently weak.

During the previous quarter, Wayfair posted revenues of $4.3 billion, up 83.7% YoY, and net income of $273.9 million. Active customers rose to 26 million (46% growth YoY), and repeat customers drove orders up higher, adding 12.7 million to the mix.

And although active customers soared and repeat customer engagement was strong, long-term net revenue per active customer fell 1.6% YoY to $440; average order value also fell 11% YoY to $227. So, while the trends to active users have been strong, order value and revenue per customer have not performed as well – are customers buying less, are prices falling, or is Wayfair having to run promotions and deals to drive orders higher?

Wayfair’s profitability has been hard to come by, and yet, the metrics that are needed to sustain profitability are huge. For Wayfair, “as long as it continues to increase revenue at least 20% year over year or more,” it can remain profitable. That does seem sustainable in itself, but the underlying trends in revenue growth have been weakening.

Data by YCharts

Aside from the previous quarter, YoY revenue growth has been declining, falling steadily from 41.56% YoY growth in Q2 2019 to 19.81% YoY growth in Q1 2020. While the current quarter relieved much of the tension in declining revenue growth on a quarterly basis, the profitability arguably had been the most important facet of the prior report.

Net income growth and margins have been terrible simply because Wayfair’s operating expenses have been growing at a faster rate than revenues and gross profit (again, aside from the previous quarter, where revenues were turbocharged). Wayfair’s profit margin is positive, finally but has consistently been negative and could easily return to the negatives once more, due to the trends within Wayfair’s expense growth.

Financially, the quarter did help Wayfair to bolster its balance sheet from an asset standpoint, as total assets grew $1.8 billion due to a $1.2 billion increase in cash and investments. However, Wayfair’s worrisome trends within liability growth still exist – long-term debt is ~$2 billion, up ~$1.25 billion YoY and up $500 million this year. So, Wayfair still has more liabilities than assets, giving it a shareholder deficit which is typically a sign of distress.

Source: Seeking Alpha

Not only does Wayfair have a shareholder deficit, but it also has been widening consistently over the 5 quarters prior to Q2 – the only reason that Q2 did not show a continuation of this trend was because of the cash that Wayfair had generated. But, if Wayfair had earned 10% less revenue, then it likely would still be nearer to a $1 billion deficit, as net income would likely have been closer to zero due to expense growth.

And that’s exactly the problem with Wayfair. It’s still a growth company with reasonable growth prospects and strong historical growth rates, but it’s also growing in the wrong way. Wayfair’s growth is not organic – it’s supported only by ever-increasing expenses (marketing/advertising) and debt issuance. Relying on that for growth will never be sustainable.

Wayfair’s customer acquisition cost is too high for it to concede and try to manage its advertising/marketing expenses, as the industry is still quite rife with competition from names like Amazon (AMZN) and Overstock (OSTK). There have already been concerns “that customer acquisition costs are rising faster than contribution margin per customer.” And coupling that with a competitive, low margin operating structure in the online furnishing realm, ad spend is necessary to drive repeat customer interaction as well as new customer attraction.

Wayfair did show that it was able to attract new customers and bring in larger quantities of orders from repeat customers, but home furnishing is not a very fluid market, in that aside from buying large pieces every once in a while (couches/tables/etc.), purchases will be minimal. And that corresponds with a lower order value overall. So, even though Wayfair could be drawing in new customers, those customers, on average, are spending less, leaving the possibility that the big purchases are done, and that the wallet share tailwind that Wayfair is expected to gain from the transition to e-commerce could already be slowing.

$2.1 billion in cash on hand could still start to disappear quite quickly if the company reverts back to net losses soon, especially if the company decides to redeem some of the $431 million in 2022 maturing bonds it has outstanding. Wayfair issued these bonds back in 2017, with an initial conversion rate of 9.61 shares per $1,000 principal, giving a conversion price of $104.06.

Wayfair is unable to redeem the notes until September 8, 2020, but that date is quickly approaching; whereafter, Wayfair “may redeem for cash all or part of the notes if the last reported sale price of the Company’s Class A common stock has been at least 130% of the conversion price then in effect for at least 20 trading days.” That would be equivalent to $239.34, which Wayfair has closed above for 17 days as of August 20 and will hit day 20 by August 25. That gives Wayfair the possibility of redeeming some or all of the outstanding notes, but for cash instead of equity. Doing so would help Wayfair to reduce its outstanding debt but would also require up to one-fifth of its cash on hand to be used for this purpose.

Overall, Wayfair is an interesting story of growth, with revenues growing at solid rates quarterly but expenses growing more. Trading at a shareholder deficit, consistently so, puts Wayfair in signs of distress – regardless of the growth story behind the stock and the fanfares for profitability, Wayfair simply isn’t safe yet due to one good quarter. Wallet share could be slowing due to the nature of home furnishing as mainly durable goods, and the average order value is falling as well even as customers grow. Wayfair’s customer acquisition cost is still likely exceedingly high, driving expenses higher each quarter, which only accumulates losses. With Wayfair’s heavy reliance on debt issuance to raise capital to burn on advertising and marketing, the long-term prospects seem muted; the idea that consistent 20% YoY growth in revenues leading to profitability seems farfetched since growing revenues 20% YoY from previous quarters puts revenues below $3 billion, but growth from $4.3 billion is not achievable yet. Because these factors do align with an implied CCC rating and a higher probability of distress/default, Wayfair should be tread with caution as it trades around its current sky-high valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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