At this point, there’s no alpha in betting on a housing market downturn or economic slowdown, and you don’t need to be a macro guru to see the many signs that are pointing to a recession. Long end treasuries yields are dropping, leading to yield curves inverting, commodities are plummeting, consumer confidence is down, China is still pursuing a zero-covid-19 policy (and could potentially be in a secular decline), and the U.S. Federal Reserve is maintaining its hawkish tone through it all.
At a micro level, we’ve had Restoration Hardware (RH) lower revenue and operating margin guidance for FY 2022 due to the deteriorating macroeconomic conditions. Analysts and investors have lowered expectations for this industry and are expecting more lowered guidance from home furnishers to come.
Where does Wayfair Inc. (NYSE:W) fit into this picture? According to its annual report, Wayfair targets households with income between $25,000 and $250,000. This means macroeconomic factors will influence Wayfair differently than Restoration Hardware, which targets the luxury market. But channel checks have shown that demand is dropping for home furnishers that don’t target the luxury market. This makes sense, as consumers cut back on discretionary spending with economic uncertainty looming.
The market has reflected these lowered expectations with Wayfair down 73% year to date, and most other home furnishing businesses down big. But after Wayfair jumped 20% in the past few weeks, I struggle to find reasons for upside from here.
Similar to how it doesn’t take a macro guru to predict a slowdown in GDP, it doesn’t take a stock-picking guru to point out that Wayfair has relatively weak financials compared to its peers. This is despite very impressive top line growth that was taking place even before the pandemic. But the lack of profits and cash flows seems to stem from high SG&A expenses which have just about equaled gross profit for the past 10 years. This trend was bucked in 2020 when gross margin jumped from about 24% to 29%, but in 2021 SG&A spend was once again higher than gross profit. This is not a sustainable trend over the long term.
Notice operating expenses versus gross profit in the chart below.
Will Wayfair be able to change the trajectory of this trend anytime soon? I struggle to find a reason why it will. Costs will surely fall with commodities dropping but I’m not sure if consumers will be willing to pay high prices to sustain high margins. We’ve already seen many big box retailers dropping prices to clear inventory and while Wayfair is relatively inventory light, I don’t think this is an economic environment where high demand will fuel high prices.
Even with a lower gross margin, increased total volume of goods sold on the platform could raise gross profit to a degree where it could be higher than SG&A spend. But again, in this environment that seems highly unlikely. Not only is there economic uncertainty, but forward looking inflation expectations recently dropped to a significant degree. From the New York Fed in its June Survey of Consumer Expectations, 3 year inflation expectations dropped from 3.9% in May to 3.6% and 5 year inflation expectations dropped from 2.9% to 2.8%. If this trend continues, consumers may hold off on purchases today in order to take advantage of reduced prices in the future.
It also doesn’t seem that Wayfair will reduce SG&A spend to a significant degree as they continue to invest for long term gains in market share. This is most evident in their international expansion. Outside of the US, Wayfair operates in Canada, Germany and the United Kingdom. In 2021 international revenue grew marginally and was 18% of total revenue but adjusted EBITDA loss from this segment expanded 76% to $168 million in the same period. This doesn’t seem to be improving in 2022 with Q1 adjusted EBITDA loss of negative $83 million from the international segment. This could be much worse in Q2 and potentially beyond as the dollar could continue to show strength relative to other currencies.
Before getting into this trade, I consider myself a long term investor. I think I’ve studied enough great businesses to spot certain long term competitive advantages that could lead to outperformance over time. At this point however, I’m not confident enough to make any long term predictions of market share gains for these home furnishing businesses. This trade idea below stems just from my thoughts on valuation and the current macro environment. This is also a fun thought exercise for myself; I’m looking forward to checking back in on this trade in a few months.
Wayfair’s stock is down 73% year to date, so much of the above bad news could be baked in. This also applies to the market in general as equities and long end bonds rallied last week despite bad CPI data. From my understanding, this reaction means the bond market is quite adamant that the federal reserve will over tighten and cause a big slowdown in GDP a few years out. This sounds bearish for equities but perhaps the equity market is seeing the short end of the yield curve rise signaling that strong short term demand will lead to decent earnings over the next few quarters.
The below chart shows the recent 10 year - 2 year treasury yield inversion.
I generally don’t have a short portfolio and I don’t plan on shorting Wayfair, but if I were to short Wayfair, I would go long another home furnisher to hedge against a continuing equity rally. In my opinion being long Restoration Hardware would be the best way to do this.
Valuation-wise Restoration Hardware is clearly in a better spot with consistent profitability and cash flow. Yes, Wayfair has grown much faster over the past 10 years, but they should both see a decline in revenue over at least the next year. And in a straightforward sense, Restoration Hardware is the better business with a gross margin of about 40% compared to Wayfair’s 24% gross margin. This is obviously a reflection of the different target customers but it also shows some level of pricing power. Finally, Restoration Hardware does not face the same currency exposure risk that Wayfair does as it does not operate in international markets as of now.
From a macro perspective, Restoration Hardware services the luxury market which is somewhat more resilient when facing the effects of inflation or a recession. I think both markets will rise and fall with the economy in the next year but the luxury market could prove to be slightly stronger.
In the short term, stock price moves come down to expectations. With Wayfair, a lot could already be baked into the stock price; it’s down 70%+ year to date and it’s one of the more crowded shorts with an almost 30% short interest (again, it doesn’t take a macro guru to see the signs that growth may slow). But with the stock up 20% in the past few weeks, the risk of shorting is much lower. On the other side, Restoration Hardware’s already preannounced lower FY 2022 earnings guidance so expectations are already quite low. But like Wayfair, Restoration Hardware is up 20%+ in the past month so upside could be reduced if economic and earnings expectations drop. In general I think Wayfair and Restoration Hardware will move together but Restoration Hardware seems to be in a better position both from a valuation and a macro perspective.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.