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Wayfair: Stick a Fork In It, Because It’s Done

Deep CaptureMar 1, 2020, 2:03:18 AM

by Patrick Byrne

Wayfair puzzled me since Goldman and Bank of America/Merrill Lynch re-purposed the $1 billion husk of CSN Stores a decade ago and relaunched it as “Wayfair”, a firm whose entire business model seemed to be to go to every vendor of Overstock.com and say, “We want whatever Overstock gets. We want whatever Overstock buys. We want whatever price Overstock.com receives.” We heard it across the entire industry: that was how they got going.

As far as we could detect, Wayfair did come up with precisely one innovation in their business model: they took the same products we and other folks (e.g., Wal-Mart) were selling, changed the Manufacturer’s ID# from #123456 to #123456W (or eventually, something less obvious), marked them up 15% over our price, and hired a legion of copywriters and photographers to generate original creative for it. Why? Because the Google-bots are now sophisticated enough to AI-match products across various websites. Wayfair was trying to charge more and beat the fact of price comparisons by having their own original copy, photographs, and Manufacturer’s ID#. That’s it. That’s the business model.

Put more succinctly, Wayfair’s business model was to enter the most commodified marketplace in history (the Internet) with commodity products it sought to decommodify by paying an army to generate creative that would trick the Google search-bots, so that Wayfair could go to all of our vendors and get everything they could, hoping the products would not be directly comparable to ours and other sites’ (even though they were, in fact, the same products), so they could charge 15% more than Overstock.

That’s the business model upon which, by the end of 2020, they will have burned $5 billion.

I always felt it might be unseemly to write that while serving as CEO of Overstock.com. It seemed… petulant? But now that I have no skin in the game (I am not a shareholder), I cannot be accused of ulterior motives. I just would feel better if I let the marketplace know.

Some ask me, What does the future have in store for Wayfair?

Allow me to present some data on why you might believe what I am going to tell you. Simply put, I know something about running a furniture-drop-shipping-pure-play-eCommerce website, arguably, more than just about anyone you can think of. After the Great Recession, we did this:

Note that in one of those years, our post-tax was actually ≈ $80 million (as I recall) because of a beneficial tax effect that I exclude here. Any competing firm would include it and it would pass without notice, but I know that if I did I would be accused of being misleading, so I have always excluded it.

Along came Wayfair. They copied Overstock’s business model to the letter, hired massively, outspent us on television by as much as 12-to-1, grew and surpassed Overstock, never made a dollar of profit (in fact, I believe that by the end of 2020 they will have burned through damn near $5 billion)…. and at some point were getting valued around $12 billion.

Buffett says, “Sometimes a man has to rise above his principles.” It is ironic, because the principle that I “rose above” is one he taught me: “In the short run the market is a voting machine, but in the long run the market is a weighing machine.” Sometime in 2017 I began wondering how the market could value us so differently for so long, and wondered if I was missing the boat. We had something about as rare as a mermaid, a profitable B2C website, but nobody would give us credit for it (after all, I had been in the public markets for 15 years waiting for “the long run” to show up), but perhaps if we just accelerated to >20% growth, creating a Wayfair-lie income statement but with far skinnier losses, we might start getting a nutty valuation too. Then we could capitalize off that as Wayfair did.

In addition, during the sale process we often heard from potential acquirers, “We know how to make money, show us you can grow!” All but one indicated they understood we would need to show large losses to do it. One said, with no trace of irony, “We are only interested in a B2C website that grow 30% profitably!” This, while they had never such an animal (I think Overstock may have achieved that once, but I am not sure another has [perhaps Etsy?]), and they themselves had spent over $3 billion for something losing, as I recall, $1 billion.

In any case, I foolishly announced to the world we were hitting the afterburners, then did so. That worked out as follows.

And though traffic growth did break through above 20%, with sales accelerating (but lagging a bit behind), we learned that the market did not care at all. Sometime in 2018 I looked at the income statement, threw up all over myself, and throttled back.

I do not know yet how Overstock fared in 2019. I do believe, “Much better”. At the start of the year I thought we might do as much as $120 million better on the bottom line for the full year (on a calculation defined by lawyers and accountants in SEC filings), and I told the world I thought it would do at least $100 million better. Right now I truly know nothing beyond what the public knows, along with my sense of things from having run the firm for 20 years. And from looking at Wayfair’s numbers.

Glancing at Wayfair’s numbers, however, tells me that that there is something secular going on deep within our economy. I began hearing of something in the real estate market starting just after Labor Day, a downshift audible to those who know where to listen. Then came the sputtering repo market (a knowledgeable friend gives me this explanation: JPMorgan had been acting like a mini-Federal Reserve to smaller banks, the vig got too narrow or disappeared, they pulled out of and that cost the system so much liquidity it created the ripples in the repo market we started seeing last autumn). So even before we get to Covid-19, Wayfair’s numbers suggest to me some kind of systemic downshift. (Throw Covid-19 on top of that, and its anyone’s guess: do people shop from home in a quarrantine? We may find out.)

Setting the macro-economics aside and returning to Wayfair: What’s in store for them? They’re done. Here’s is why. Their overhead is being covered less and less covered by what their operations generate to pay their overhead, which is to say, their Gross Profit minus their advertising costs, or what was once known as “Contribution Margin” (a point made to me years ago by the good people at Allen & Co.)

For 2019 43% of their overhead was covered by their Contribution Margin. That means that to get to break even they would have to cut 57% of their overhead (which would mean about 2/3 of their people): it is hard for anyone to do that without nicking an artery, but Wayfair has not shown a proclivity for cutting in any case. And imagine if they did eliminate that much of their overhead: presumably those people were contributing something, they will be gone so Wayfair will lose that something, and the Contribution Margin will also drop. That puts them in a death spiral.

Will the capital market save them? By the end of 2020 they will have lost $5 billion with no end in site and nothing remotely looking like “a profit” (not even on some adjusted triple-reverse-Earnings-Before-Expenses basis). To anyone considering funding Wayfair with additional capital, please feel free to forward (royalty free) this robust counterargument:

Will they be purchased for their technology? The idea is not dumb, actually. There are some massive home-related brick-and-mortar retailers who more or less sat out the last 20 years and have websites about which they are embarrassed. Such are the advantages of a hybrid brick-and-click model in home goods, that if they don’t buy good technology (they will never develop what they need in-house and they know it), then over the next 10 years they are all going to be roadkill for Amazon, Wal-Mart, and Target. Truly, anyone else who thinks they have a moat is going to learn that those three firms use the hybrid model to absorb all neighboring models.

So such firms are in quite a fix. Wayfair is good technology, and buying it would let one of those large brick-and-mortar retailers solve their problem with one huge check. But Overstock is better technology and trading at 1/20 of the cost. How can we know it is better technology? Again, to any candidate acquirer of Wayfair, feel free to send this robust argument:

The reason Overstock stands virtually unique with that record is not because of its brand, its not because of its CEO, its because of its technology. And technologists. And teams that integrate business leaders and technologists. Given that Wayfair has never and will never produce anything like that in its history, while Overstock did on an amount of capital about equal to what Wayfair lost in the last 90 days, any potential acquirer of Wayfair would be massively overspending on an Edsel while they could be buying a Porsche at 1/20 of the price.

Wayfair will try to get there, but not by leaning out their whole operation. They need to cut off a limb immediately. The move I would expect would be for them shut down their massive German expansion. Maybe all of Europe. Then Canada. Yet the problem that is keeping them awake nights about that is this: “As we shut down these operations we are still going to hemorrhage huge losses, and so we are still going to need fresh capital. But the market valued us as a growth stock, and as we shut down those operations we will lose our luster, our valuation will collapse, and then we cannot fund ourselves.”

Meanwhile, as they deliberate that chestnut, they are staring at something else: I believe you will see their Q1 growth drop under 20%. While a growth rate in the high teens may still be impressive, they will no longer be in “high-growth territory”, and their valuation will collapse anyway. (Note to Wayfair: since that Rubicon will be crossed this quarter, as you and I both see, it is best that you do that chopping right away so that when you have to report slipping below 20% you will also be able to report having at least started the expense adjustments. And no, I do not mean last week’s 3% RIF.)

So Wayfair is not going to get funded by the capital market and it is is not going to get sold and they probably cannot (and almost certainly will not) match their expense structure to their Contribution Margin (and even if they did, that Contribution Margin would collapse and they would be in a death spiral). How about their vendors?

On any normal day Wayfair abuses their vendors, with payment terms about 20 days slower than Overstock, as I recall, (and Wayfair stretches outs its vendors even on its own generous-to-Wayfair terms, while OSTK has maintained a perfect Paydex Score of 80 for about 99% of the last decade: I always wondered why vendors agreed to be a bank for Wayfair, yet never gave Overstock better treatment). Yet rumors from the world of vendors reached me in the last week suggesting that Wayfair is now telling vendors: “Prepare to be stretched out even more!” Those vendors may agree to expand their side-business of being little banks for Wayfair: If they do, they are going further and further into the business of picking up dimes in front of a steam-roller. Most days in the future they will make a dime.

So Wayfair will not be be financed any longer by Wall Street, no one in their right minds would buy them at anything like their current price (especially when they could get better technology in OSTK at 1/20 of the price), they cannot cut enough now to save things, and their vendors may eventually decide they don’t want to be Wayfair’s bankers (and in fact could actually create the vendor-equivalent of a “run on the bank” just from not wanting to remain in the business if financing a firm that this year will burn through its five-billionth $1 bill).

So Wayfair is as done as done gets. The public market can thank Goldman and Bank of America/Merrill Lynch for that one.

If only there were a pattern, if only there were a pattern…

Right now the best strategy for Overstock is (in my view) to rope-a-dope. Not to worry one moment about growth, but simply to hang back and maximize Contribution Margin by refining technology, and adjust the expense structure as needed. When your opponent is destroying himself, don’t interfere. Wayfair drove down a cul-de-sac from which there is no return.

If you agree with what I just wrote and you are an Overstock shareholder, you should not worry one iota about growth in Overstock Retail until the Wayfair farce plays itself out to its ugly, ignominious, and inevitable end.