By Parke Shall
Wayfair (NYSE:W) has been a subject of controversy for the last 6 to 12 months as bullish and bearish sides have argued over the true intrinsic value of the company at length. Bulls say that Wayfair is the next Amazon (NASDAQ:AMZN) and that it could grow up to be just as large as Amazon was a couple of years ago. Bears say that it is in an unprofitable business with poor margins and no real chance of gaining bottom-line traction at any point.
We think there's a good argument on both sides of the coin. We also think there's an ideal market environment for each of these arguments to hold up, and in today's environment the bearish argument takes it by a mile. In this article we wanted to explain why we think the macroeconomic timing is wrong for Wayfair longs and why we would not be an investor here.
The stock has been a roller coaster for investors, but has provided almost no consistent return for the last year.
The debate on Wayfair got a thrust into the limelight when short seller Citron Research released a report on the company claiming basically that it was worthless. To the company's credit, it has held up very well since then, as you can see from the chart below. It has not returned a significant amount for shareholders, but in the face of constant criticism the company has held its own, as you can see in the above chart.
Adding to this momentum is the fact that the copmany's top line continues to grow at an aggressive rate. As promised, sales continue to rise at an impressive clip, leading potential investors to believe that when Wayfair goes to turn the profit switch on, they are going to be sitting on a cash-generating behemoth.
Bears on the other hand want to focus on the bottom line a little bit more. What good is $1 billion in revenue if you're not taking home any cash from it at the end of the day? Here is what the company's cash generation and net income figures have looked like, which tell a much different story than the company's revenue line.
As most people know, we are at all-time highs now and whether or not you believe this is because of strong fundamentals or because the market is hitting peak euphoria before correcting, you have to admit that it is going to put rate hikes back on the table heading into the back end of this year.
We have argued extensively that rate hikes are actually a notional positive for the market, indicating that the market is now healthy enough, and that they should be viewed as positive. However, this is not the case, and rate hikes usually proceed a pullback in equity markets, regardless of the reason they occur.
If Wayfair had started getting to the point where it is now back in 2009, it would have had a long runway of low interest rates and easy expectations from the market in front of it. We believe Wayfair could perform well in that environment, as it has over the last five years.
But something happens when rate hikes rise and the market jolts a little bit as a result. We generally tend to see a shift in sentiment, where general euphoria is thrown to the wayside and actual stock picking based on fundamentals starts to inch its way back into focus.
Now, with zero interest rates, we live in a world where non-GAAP numbers are fine and where companies don't need to have fantastic quality of earnings in order to be successful. Some companies don't even need to have business plans, but for overpaying for acquisitions and rolling them up into a pile of garbage, which anybody can do.
This is the kind of environment that questionable stocks like Wayfair thrive on. As long as the euphoria of the top line growth stays in tact, the story will outweigh the fundamentals and the stock should remain supported. But it is when investor sentiment makes this 180-degree turn and starts focusing on pure fundamentals that companies like Wayfair are going to have a real problem. If you don't think this shift and sentiment can happen, you haven't lived through enough market cycles.
While W continues to not have any debt to worry about, its margin and cash generation will be the two items most in focus going forward.
If the company can't improve its margin and generate cash on its own, it'll either be forced to take on debt for the first time or dilute existing shareholders, the road we think is most likely for the company.
What will happen is the often touted "flight to quality." It is called that because people move to cash-rich companies with great balance sheets, and investors settle for less earnings growth but more safety in dividends and consistency. Wayfair is simply the polar opposite of this type of equity. It is a speculative equity that may or may not be egregiously overvalued and has yet to prove to the market that it has real cash-generation power. When the market's focus becomes the amount of cash a company will generate in the future after an investment is made, companies like Wayfair will suffer.
To tie this all together, we obviously feel as though the market is at a top. We have been saying this for about the last six months now, and we continue to believe it. As with every market top, there is some churning and there are new highs. After all, the market hit new highs just days after Bear Stearns collapsed, which of course was immediately followed by enormous problems.
And this is just not as easy as saying to sell stocks on a correction and buy them when the market is at the beginning of a bull market. There are certain types of stocks that we believe are great buys on pullbacks and certain types of stocks that we would avoid in both market environments. It is only when we see an overall change in the mood from "buy everything" to "flight to quality" that we think stocks like Wayfair would perform worst. We believe that this macro shift is upon us and for that reason we would not want to be long Wayfair going forward from here.
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.