2023-05-30 13:14:50 ET
Summary
- WRBY still has room to run with its store count growth as they continue to forego profitability to drive top-line growth.
- Operating costs remain high despite recent cuts. I provide an example of what stabilized operating costs could look like.
- The stock-based compensation seems excessive, given that growth is expected to slow this year.
- Overall, these factors lead me to a sell rating for WRBY.
Introduction
Warby Parker Inc. (WRBY) is down ~77% from its direct listing price as they continue to struggle to manage costs. Although they have delivered a solid 17.35% revenue CAGR over the last 3 years, they are not yet profitable. Additionally, shares outstanding have increased 61% since 2022. My valuation approach estimates a fair value of $7.40.
Store Count Growth
The one bright spot for WRBY is their ability to deliver store count growth and the long potential runway that they have to continue to do this. The most recent earnings presentation shows that store count currently sits at 204, which is an increase of 20% yoy. However, sales lagged that growth number, coming in at +12.2%. WRBY claims that they have the potential to grow their store count to 900, meaning they have only realized a fraction of their potential store count..
Looking forward, they are expecting to increase their store count to 240 by the end of the year, delivering a respectable growth rate of 17%. Overall, it looks like management is executing their store expansion plan well and they still have a ways to go before they have saturated the market. Once WRBY's growth stabilizes, they will need to optimize their cost structure and focus on achieving maximum profitability.
Managing Operating Costs
WRBY currently spends a lot of money on driving growth in top line revenue. This is a fair strategy when times are easy and debt is cheap, but now that we are moving into a higher rate environment with inflation and a potential recession, it would be beneficial for WRBY to start to control its costs. In Q1 SG&A made up 62% of revenue, which seems excessive. According to the most recent transcript:
As a reminder, SG&A for our business includes three main components: salary expense covering our headquarters, customer experience and retail employees, and marketing spend.
Management has begun to make moves to rein in some of these costs by cutting headcount in 2022 and reducing marketing spend. Marketing spend was reduced to 11.7% of revenue compared to 20% for the same quarter last year. If I quickly take the consolidated statement of operations numbers for Q1 2022 and 2023 and assume that WRBY can reduce SG&A to 45% of revenue in the future, then they would have produced an operating profit for both of those time periods.
Author's Representation of Adjusted SG&A Expense
Is The Stock-Based Compensation Fair?
WRBY's stock-based compensation for 2022 was on the high end, coming in at 16% of revenues. Management expects this year's stock-based compensation to be 10% of revenue, which is still higher than I would like to see given that revenue growth is only expected to be 8-10% this year. Management states that:
stock-based compensation is above our long term forecast of low single-digits as a result of the multi-year equity grants to our co-CEOs in 2021.
They are currently anticipating a reduction in stock-based compensation to 2-4% of revenue by the end of next year. Although they are moving in the right direction, I would like to see a quicker reduction in stock-based compensation for this year as the percentage does not seem to align with the projected growth for the year.
Earnings Expectations
Before I dive into my scenario analysis I will use this section to explain how I chose my growth assumptions. As we can see from the chart above, consensus expectations are for WRBY to become EPS profitable in 2023 and then grow at a 70% CAGR over the next two years. I do not believe that this is a sustainable growth rate to project into the future. For that reason the highest growth rate I will use in my scenario analysis is 50% for the best case scenario and this scenario will be assigned a probability of 10%. I will use 40% for my base case to be conservative relative to consensus estimates.
Valuation & Scenario Analysis
For all my calculations of value, I will be using a discount rate of 10%. 10% is my minimum required return because this has historically been the return you can expect if you decide to just put your money in an index fund that tracks the S&P 500. Lastly, keeping the discount rate the same allows for comparability between different investments.
Also, I assign a weight of 60% to my base case, 10% to the best case, and 30% to my worst-case scenario. With that out of the way, I will move to the individual scenarios.
Scenario 1 is my base case, which assumes 40% growth for the next 5 years with a terminal multiple of 30x. Discounting the 2027 sales price back to present value yields a fair value of $8.59 for an investor with a target return of 10%.
Scenario 2 is my best case, which assumes 50% growth for the next 5 years with a terminal multiple of 35x. Discounting the 2027 sales price back to present value yields a fair value of $13.20 for an investor with a target return of 10%.
Scenario 3 is my worst case, which assumes 20% growth for the next 5 years with a terminal multiple of 20x. Discounting the 2027 sales price back to present value yields a fair value of $3.09 for an investor with a target return of 10%.
The sum of the weighted PVs is $7.40, implying ~39% downside from current prices.
PEG Analysis
After going through the scenario analysis, some might be confused at how a stock can experience 40% growth in earnings and not rise. Here I will address those concerns and explain what expectations are priced in. If I take the average of the 3 years of consensus forward estimates from stockanalysis.com that I posted in my earnings expectations section, I get 0.22. Currently, the stock trades at 54.73x this number. However, my base case assumes 40% growth which would give this a PEG ratio of 1.37. Anything above 1 means that the market is pricing in higher growth than I am modeling. This means that 40% growth would be a disappointment to the markets' expectations, usually a negative sign for the stock price.
Conclusion
Overall, there are several headwinds to WRBY that make its near term prospects appear unfavorable. Even if they do experience above average growth, the stock appears to be overpriced. As a result, I rate WRBY a sell.
For further details see:
Warby Parker: Still Overvalued Despite Heavy Discount From Direct Listing Price