Wayfair's Cash Burn Will Become A Problem Soon Enough

| About: Wayfair (W)

Summary

W continues to post torrid revenue growth.

But its margins are getting worse and heavy spending is crushing potential profits.

With cash burn significant and profitability years away, W is still a short.

Wayfair (NYSE:W) has certainly made a name for itself in the online retailing business as the growth numbers the company has posted since coming public have been absolutely staggering. The company's portfolio of popular brands has resonated with consumers in a big way but despite this, I've been bearish on W in the past. The company isn't profitable as its margins are absolutely horrendous and given this, it burns through a lot of cash. But this hasn't deterred bulls as shares continue to remain elevated and after Q1 earnings, the stock posted a nice move up on strong guidance. But with general weakness in retail in recent months, does W still have room to go to the upside?

I'll be using some charts from Simply Wall St. to help me out.

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Wayfair's success is due entirely to its torrid revenue growth. This company produces top line gains unlike virtually any other company in any sector in the market; it's astounding. In fact, W looks rather like the early days of none other than Amazon but of course, Wayfair is no Amazon; it is simply trying to use the same model of rock-bottom, money-losing prices to attract volume. And it's working.

Direct retail revenue rose 93% in Q1 and its number of active customers was up almost 70%. In addition, the average revenue in the past year per active customer was up 13%, meaning that not only is W attracting lots of new customers, but those customers and existing ones are spending more and more. That is how you post nearly triple digit revenue growth and W has become a master at it. Of course, I wouldn't dare diminish the importance of W's revenue growth because it is nothing short of amazing. But there is more to running a successful business than just selling things in high volumes.

The problem with W is that it suffers from negative operating margins due to prohibitively high costs in relation to the gross margins it collects. W's strategy is to go after volume and market share at the expense (quite literally) of profits. In short, just like Amazon, W doesn't care if it makes any money; the goal is simply to move product.

But that means that gross margins are horrendous and they fell a further 20bps in Q1 to just 24%. There are few businesses on earth that can tolerate product margins that low and still make money and W certainly is not one of them. Its costs to operate well exceed 24% and have forever and that is why W in chronically unprofitable. In fact, even with almost triple digit revenue growth, W is spending so heavily on hiring and advertising that its adjusted EBITDA is going to be negative for the entire year (again). W is spending its revenue as quickly as it is making it and while bulls will say W is investing for the future, at some point the company needs to make some money or it will need to raise capital.

So why are shares still elevated? The answer is simple; W's future growth is expected to continue to be spectacular for a long time to come. This is what analysts think W can do in terms of revenue growth for the next few years.

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The trajectory is straight up for years to come and why not? W has continued to impress with its revenue growth; it has a portfolio of brands that are hip and stylish and attract people with disposable income. What more can you ask for from a revenue growth perspective? The problem is that W is also going to continue to burn through cash for the foreseeable future as its below-zero margins take their toll.

EPS is expected to be negative through 2018 as W continues to overspend.

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The strange thing is that analysts think W will go from roughly breakeven in 2018 to earnings in excess of a dollar in 2019. But how? What's going to happen that will cause W to suddenly stop spending on advertising and hiring at the pace that it has been? W's business model is to attract as much volume as possible with low prices and one of the principal methods to do that is to advertise a lot. In addition, it will need people to support these growth initiatives so while profitability will no doubt improve over time, the ramping of EPS from nothing to more than $1 in one year seems very optimistic to me, even if it is three years away. I simply don't believe that W will reach its point of maturity where it will stop spending and produce earnings that quickly. And I haven't even mentioned its gross margins in the mid-20s; if W is to produce a dollar of EPS, 24% isn't going to cut it.

W's chronic unprofitability is taking a toll on its balance sheet as it burns through more and more cash as time goes on.

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While it has no debt, W's book value continues to fall with each passing quarter as its turn and burn strategy grabs market share at the expense of the company's balance sheet. This is going to continue for the foreseeable future and without a share sale, W's book value is going to be negative at some point in the not so distant future. Its cash burn is simply too great to overcome with its present business model. That's not a problem for today but it will be a problem soon enough.

On a valuation basis, W is obviously ludicrously priced right now. It has no earnings and won't for some time but trades for nearly $40 anyway. And even if we assume I'm wrong and that in three years' time W will be producing more than $1 of EPS, it is trading for 30 times that level today. That would be a steep multiple if it were late 2018 and W was on the verge of being profitable but we are a long way from that. Instead, we have a company that loses money on average for each product it sells and while revenue growth is nice, its margins are absolutely horrendous. And given its cash burn, I think a stock sale is coming up in the next year or two which will dilute shareholders so W can continue to finance its volume-based model.

One thing that will keep W shares volatile is the enormous short interest in the stock. It isn't unusual to see nearly half of the float shorted at any particular time so any bit of good news can send shorts scrambling for cover. But short-covering rallies are not the basis for a sustainable rally and W lacks a basic tenet of long-term success; selling products for more than what they cost. The combination of far away profitability and cash burn makes me continue to be very bearish on W; I think it is going lower.

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.