W - Wayfair: Potential 2024 Recession Increases The Risk Of Significant Decline

2023-11-20 14:58:44 ET

Summary

• Growing volatility in consumer credit and spending trends pose a potential risk for retailers, including Wayfair.
• Wayfair's financial position is precarious, with declining revenue per share, negative operating margins, high levels of debt, and negative working capital.
• The company may struggle to refinance its debt and maintain positive operating cash flow, making significant financial strains a possibility in 2024.
• Wayfair's immense stock-based compensation effectively dilutes its equity by over 10% per year.
• A decline in Wayfair's market capitalization could exacerbate issues due to its dependence on convertible debt and equity compensation.

As discussed in my recent articles, growing volatility in consumer credit and spending trends are a potential cause for concern for retailers. Retail companies performed very well in 2021 due to pandemic savings. However, as that has resulted in a rise in inflation and a significant decline in household financial stability, we're now seeing strong indications of an impending reversal in consumer spending. To me, the most important sign is the acceleration in consumer delinquency rates, now well above pre-COVID levels, pointing toward a decline in consumer discretionary spending from Q4 onward. If this prediction pans out, retail companies with poor financial positioning may risk severe losses or financial issues.

Wayfair is among the few online retailers that I believe are at much higher risk. I covered Wayfair ( W ) around the beginning of the year with a bearish outlook . The stock has performed well overall since then as it rose dramatically in what appears to be a "dead cat bounce." Although I had a bearish view on W in February, I noted that I would not short the stock then due to its high short interest pointing toward a short squeeze risk.

Now we've seen the short squeeze playout. At the same time, its prospects have continued to deteriorate, making a short position more viable than before, mainly if we assume a high probability of a consumption-driven recession in 2024. Given its technical position, I believe it is an excellent time to take a closer look at the firm to see how it has developed over the past two quarters. Overall, it appears to me that more significant financial strain is likely in 2024; however, the firm is also making some changes that could prolong its lifespan.

Wayfair In A Financial Hole If Not For Dilution

In my opinion, the sharp rise in Wayfair's stock months ago was not driven by a fundamental rebound but primarily by an unsurprising short squeeze. Wayfair's revenue, mainly its revenue per share, has continued to decline steadily. Its gross margins have improved materially but remain far below its operating costs-to-sales ratio. See below:

Wayfair has improved its profitability since I covered it last, but it is still far from where it must be to survive. Its operating costs account for ~5% more than its gross margins, meaning its margins remain consistently negative. Some investors will point toward its slightly positive free cash flow during the last two quarters as a bullish indication. Its stock-based compensation was still $139M in the previous quarter, far more than its $42M free cash flow. While that is a good point from a liquidity perspective, investors should not write off its tremendous stock-based compensation rate that accounts for 4.7% of its sales. Given that most retail stocks can expect (at best, 5% margins, most being closer to 2%), it is a huge red flag that it pays so much stock-based compensation.

Despite its slightly positive free cash flow, Wayfair remains in a financial hole. The company has $3.2B in debt. It has consistently negative EBITDA, making it difficult to repay that debt and likely creating refinancing challenges. Due to that, its debt is all convertible, with its more recently issued 2027-2028 notes having $63.5 and $45.8 conversion prices, respectively, meaning significant dilution is likely if the stock rises from its current level. Its closer-to-maturity notes were issued when its stock price was much higher, making dilution a negligible risk. 2024, it has $117M in debt to repay, with an additional $754M in 2025 and $949M in 2026.

Wayfair may refinance its 2024-2025 debt through new convertible notes, although likely at a much higher rate. Its 2024 and 2025 notes have low effective interest rates of 1.5% and 0.9%, respectively, but its more recent 2028 notes are at 3.8%. Interest rates have also risen since then, so I expect its new rates will be closer to 5% if it refinances. Of course, that will also be at a lower conversion price, meaning its income potential would be considerably lower while its dilution risk is much higher. Its total market capitalization is $5.6B today. In comparison, its debt is $3.2B, meaning its outstanding shares could rise by ~57% if all of its debt is eventually refinanced at conversion prices close to its current share price (and converted near such levels). Even then, without a clear path to profitability, I expect it will face even more significant financing issues given the tightening of lending standards.

Wayfair's working capital is now -$212M, partly due to its 2024 repayments, but it would be negative even without the debt maturity, primarily due to its $1.17B accounts payable. Its EBITDA is also around -$50M per quarter, indicating it is unlikely to maintain a positive operating cash flow without continuing its extreme stock-based compensation rate. See below:

As some analysts have pointed out , the company's "adjusted EBITDA" is positive; however, as noted in the fine details of its 10-Q , the non-GAAP EBITDA figure does not account for stock-based compensation. That is essentially the only functional difference between its non-GAAP and GAAP EBITDA, adding $139M to its "adjusted" figure. Wayfair's stock-based compensation rate is 10.2% of its market capitalization. While I find this inappropriate from a managerial standpoint, the company is forthright about its equity compensation. Hence, it is up to investors and analysts to do the appropriate due diligence. Still, any usage of its non-GAAP EBITDA is, to me, an entirely useless figure for this reason.

The fact is that Wayfair may manage to extend its life if, and (likely) only if, investors continue to give it a higher market capitalization. Its high market capitalization of $5.6B allows it to dilute equity through stock-based compensation and, most likely, through convertible debt sufficiently that it can maintain some liquidity even with around $900M-$1.35B losses. The company has lost $915M on a TTM basis and lost $1.33B in 2022, though many expect some improvements going forward. If its valuation falls enough, it will no longer be able to use those measures, likely rapidly depleting its already negative working capital.

Wayfair's Macro Headwinds Just Starting

The other potential, of course, is that Wayfair manages to earn consistently positive operating income. The improvement in its gross margins is a minor point in that direction. A significant reason is the decline in freight and shipping costs, which is a massive factor for the company, given it sells bulkier and heavier items. While it performed very well in 2021 due to "pandemic savings," that era also saw a steep rise in fuel costs due to global supply cuts the year prior. Since then, we've seen a general normalization of demand and supply-side factors, creating macroeconomic volatility for Wayfair.

Significantly, I disagree with its manager's take that it had faced macroeconomic headwinds this year, as discussed throughout the last investor call. From a broad US consumption and economic activity standpoint, the 2022-2023 environment has been relatively stable. We're not seeing the same extreme demand in 2021 when consumption activity skyrocketed due to stimulus and savings (the "buy furniture instead of vacation" trend). The 2021 period was an extreme anomaly that required a doubling of the US money supply and that of many Western countries.

The 2023 environment resembles a typical "slow and stable" growth environment with little GDP volatility , contradicting its manager's discussion of macro volatility. It is true that 2023 has been a weaker period from a macroeconomic standpoint than 2021. However, if Wayfair is struggling with this macro volatility during a stable period, then its prospects of a true recession are potentially very weak.

As we're seeing more clear indications that consumer activity is peaking, likely around Q3 , I expect to see more real macroeconomic headwinds in the current quarter, with potential recession patterns in 2024. In other words, if Wayfair is concerned about macro headwinds this year, which are objectively mild if positive , then I do not believe it can handle the shock coming for it in 2024. Of course, a consumer-driven recession is not guaranteed, and, to be fair, I had expected headwinds to form in 2023 that have not occurred as fast as I anticipated. That said, I believe the data quite clearly points toward a slowdown. See below:

Wayfair's gross profits generally correlate to US retail sales adjusted for inflation. US real retail sales have stagnated since 2021 but remain far above pre-COVID. Due to the declines in consumer sentiment and personal savings and the rise and fall in consumer credit growth, I believe we will likely see a sharp decline in real retail sales next year. Put simply, if people do not have much savings and no longer borrow significantly on credit cards, they're likely beginning to reduce discretionary spending. While some believe that falling inflation may improve that trend, I think it is more likely that inflation is slowing because consumer demand is souring, not the other way around. We're also seeing very high business growth slowdowns, as seen in the manufacturing PMI and high recession probabilities from interest rate models.

Obviously, we cannot predict a consumption slowdown with 100% accuracy because external variables and events can always change outcomes. That said, from a data-driven standpoint, the odds of that occurring in 2024 are the highest since the last significant consumption declines, if not higher. In my opinion, Wayfair's financial position implies it cannot afford the 10-30% decline in sales that would likely occur during a recession. Further, as detailed earlier, a decline in its market capitalization due to recession concerns could be enough to cause financial issues due to its dependence on equity dilution.

The Bottom Line

Overall, I am very bearish on W and believe its fundamental position is worse than last I covered it. The stock's price is higher than in February but is not seemingly at a high probability of returning higher as it already had a major short squeeze earlier this year. Still, its short interest is 25%, so a short squeeze is still a considerable risk. As some short demand has declined, short borrowing costs have fallen to near-zero , given its low carry risk. Its implied volatility is high at 66%; however, that is at the 17th percentile of its normal range, indicating put options may be undervalued or a decent way to bet against it with defined risk.

There are significant risks in shorting W. Although I believe W's long-term survivability is limited due to its negative EBITDA and working capital, a substantial decline in its operating overhead could improve its prospects and cause the stock to rise. In my opinion, Wayfair's product quality is not sufficiently high to maintain a stable customer base, creating immense costs associated with returns and shipping due to the weight and volume of its products. Furniture is among the few items that are likely the most competitive in a physical store setting. Even then, if it were not for poor financial practices such as extreme stock-based compensation and rapid debt expansion, Wayfair's survivability may be more feasible.

One other major risk in shorting W has been seen this year; that is a short squeeze. Short sellers must remember that W may rise without fundamental improvement due to a short squeeze or speculative rally, so tight stop losses are necessary. It will be interesting to see how the company performs over the next year. Without a recession, I would not be surprised to see it last through 2024. However, if a recession occurs, then I believe it may be among the first retailers to suffer more significant declines.

For further details see: