Wayfair Inc.
Q2 2019 Earnings Call Transcript

Published: 1 Aug 2019

[Operator:]

Good morning. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the Wayfair Q2 2019 Earnings Release and Conference Call. I would now like to turn the call over to Jane Gelfand, Head of Investor Relations. Please go ahead.

[Jane Gelfand:]

Good morning, and thank you for joining us. Today, we will review our second quarter 2019 results. With me are Niraj Shah, Co-founder, Chief Executive Officer and Co-Chairman; Steve Conine, Co-founder and Co-Chairman; and Michael Fleisher, Chief Financial Officer. We will all be available for Q&A following today’s prepared remarks.

[Niraj Shah:]

Thanks, Jane, and thank you all for joining us this morning. We are pleased to report a strong Q2 and we remain as bullish as ever about what lies ahead for Wayfair. We continue to see our investments across the business payoff, driving value to both our customers and our suppliers and enabling us to capture an outsized share of the dollars that move online each quarter. In the U.S. our strong momentum in both percentage and dollar terms continues. In Canada, we’re seeing sequential acceleration and growth, and the UK and Germany are tracking in line with the high expectations we set for ourselves, reflecting customers growing awareness and appreciation for the Wayfair brand and shopping experience. Today, I’ll provide you with an update on our logistics network, which is a major differentiating advantage for us and a source of improved cost efficiencies. I also want to talk briefly about the special set of supplier events, we hosted this past quarter, which showcase a true partnership we share with our suppliers. And as our quarterly practice, I will highlight the exciting initiatives we have underway in one of our categories. Today, our focus will be on the outdoor furniture business, which was a strong driver of growth in the first half of 2019, despite seasonal variability and is yet another example of a category where we are consolidating share as the business moves increasingly online.

[Steve Conine:]

Thanks, Niraj. I would like to take a few minutes to update everyone on our newest brand Perigold. With Perigold, our opportunity is to disrupt the luxury home market with an e-commerce marketplace that the luxury customer expects, just as we have with the mass market customer and wayfair.com. This is a huge opportunity with the high end home goods market in the U.S. measuring north of $70 billion by our estimate and also underpenetrated in e-commerce. Our mission at Perigold is to reveal an undiscovered world of luxury. We’re targeting customers and professionals who are increasingly comfortable transacting online but are underserved in luxury ecommerce platforms for home. They are also largely incremental to those we currently serve on wayfair.com. Part of the Perigold customers challenge has been a supplier universe that is nascent to the digital world and initially somewhat reticent to participate. When we first launched our team of fewer than 10 people had to onboard suppliers, convey the benefit for the e-commerce model and convince them that Perigold could represent a large and rapidly growing revenue channel. Today Perigold features over 500 suppliers with a rich pipeline of additional one still to join. Some of the prominent luxury brands that already called Perigold home include, Lillian August, Schumacher, Arteriors, Currey and Company, Century Furniture and JANUS et Cie. With a dedicated team of now over 70 people, we continue to gain traction, recognition and legitimacy amongst suppliers and have been able to more than triple the number of products on our site since the launch. A few months ago, I traveled to Milan for the Salone del Mobile trade show, a design event that draws more attendance than Fashion Week. There I had the opportunity to meet with key suppliers both present and perspective and was really impressed by the level of trust our suppliers are placing in us and the reputation we’ve established among the luxury community. Suppliers are having success partnering with Perigold and in turn are spreading the word to their peers, keeping the flywheel turning and furthering the inroads we are making. The conversations and enthusiasm remind me of the inflection point we witnessed with Wayfair.com several years in visiting mass oriented trade shows like High Point in the U.S. In Perigold’s case, because luxury suppliers have historically, have very little or no exposure to e-commerce. We partner closely with our suppliers to develop uniquely tailored digital assets in both 2D and 3D visualization tools and merchandising strategies.

[Michael Fleisher:]

Thanks, Steve, and good morning everyone. I will provide some highlights of the key financial information for the quarter with more detailed information available in our earnings release and in our investor presentation on our IR site. In Q2, our Direct Retail business increased 42% year-over-year to $2,332,000,000, representing year-over-year dollar growth of approximately $690 million. Our total net revenue also increased 42% year-over-year to $2,343,000,000. In the U.S., Direct Retail net revenue increased to $1,989,000,000 in Q2, up 42% year-over-year, representing year-over-year dollar growth in the quarter of approximately $590 million. Direct Retail net revenue from our international segment, which includes Canada, the UK and Germany increased to $343 million, up 41% year-over-year, and up approximately 47% year-over-year on a constant currency basis. As a reminder, our revenue from Canada is significantly larger than our revenue coming from either the UK or Germany today. In recent quarters, we experienced revenue growth headwinds in Canada due to a combination of external macro and currency headwinds and a temporary cost disadvantage as we sourced product into the U.S. first before crossing the border into Canada. We expect the second factor to gradually lift as we induct more product directly into our Canadian Mississauga facility and did impacts the year-on-year growth in the Canadian business, sequentially accelerate in Q2 relative to Q1. Our UK and German businesses continued to outpace our overall company revenue growth rate and are hitting key internal milestones. In both European markets, we have significantly increased the skew selections year-over-year with more to come. We’ve also grown more sophisticated in merchandising and advertising, which is driving higher levels of repeat purchases in both countries. CastleGate penetration in the UK and Germany also continues to march higher year-over-year. I’ll now speak to our KPIs on a consolidated global basis. We were pleased to see another strong quarter for new customer acquisition with our LTM active customer base reaching $17.8 million in Q2, an increase of 39% year-over-year. LTM net revenue per active customer was $447 and LTM orders per active customer were 1.86 in Q2. Both KPIs were up modestly on a sequential basis. LTM net revenue per active customer was driven higher by the U.S., while orders per active customer experienced small increases quarter-over-quarter in both the U.S., and international. I will share the remaining financials on a non-GAAP basis, excluding the impact of equity-based compensation and related taxes, which totals $57 million in Q2 2019. For reconciliation of GAAP to non-GAAP reporting, please refer to our earnings release on our IR site. Our gross profits for the quarter, which is net of all product costs, delivery and fulfillment expenses was $561 million, or 23.9% of net revenue. Gross margins were 60 basis points higher year-over-year and in line with our near-term expectation for gross margins in the 23% to 24% range, which remains unchanged. In Q2, advertising spend was $259 million, or 11.1% of net revenue, approximately 35 basis points higher than Q2 last year and better than our guidance of a 75 basis point increase. As you recall, our ad spend decisions are governed by or approximately one-year contribution margin payback threshold and we continue to see attractive opportunities to invest advertising dollars within this framework. We believe the success of that approach is evident in both LTM active customers and percentage of orders driven by repeat customers reaching all time highs this quarter. Our proprietary ad spend technology allows us to invest behind the highest returning customer cohorts, which tend to make repeat purchases year-after-year. As our marketing teams continue to execute on this approach, we expect advertising as percent of net revenue to increase roughly 50 to 75 basis points year-over-year in Q3. A component of this is a drag as Europe becomes a larger part of our business mix and as we continue to ramp our brand building investments there. Our non-GAAP selling, operations, technology and G&A expenses are driven primarily by compensation costs and in Q2, it totaled $330 million. In the second quarter, we added approximately 1,200 net new employees for a total of 14,548 employees as of June 30, 2019. Approximately, 850 are in variable costs areas of our business, mainly in customer service and in our logistics operation. As we continue to in-source work previously done by third-party logistics providers. Approximately, 350 of the net new hires where in OpEx areas, such as engineering, marketing, merchandising, product, operations including logistics, leadership and technology. As a reminder, Q3 2019 will show a pick up to this pace of hiring. As we welcome the tremendous new talent we attracted through our on campus recruiting efforts. Our employer brand is very strong on campus and we were able to fill positions in almost every part of our business with recruits from the top universities and graduate schools. In Q4, we plan to step down again closer to the hiring levels we saw in Q2. Now turning to profitability, adjusted EBITDA for Q2 was negative $70 million, or negative 3% of net revenue. Adjusted EBITDA for the U.S. business in Q2 was negative $342,000 rounding to roughly breakeven as a percent of net revenue. And adjusted EBITDA for the international business was negative $70 million. Non-GAAP free cash flow for the quarter was negative $91 million, based on negative $3 million in net cash from operating activities and $89 million in capital expenditures. CapEx was 3.8% of net revenue in Q2 and we expect Q3 CapEx to total approximately 4% to 5% of net revenue. As our business scales, we continue to look for the most cost effective and flexible solution for our data infrastructure. And so we are in the process of partnering with a large cloud provider to support our ambitious long term growth plans and best serve our customers. In Q3, our OpEx line will reflect $10 million to $15 million of incremental expenses related to this initiative. So we expect to be able to meaningfully reduce our CapEx spend in this area over the coming quarters. As of June 30, 2019, we had approximately $714 million of cash, cash equivalents and short and long term investments. With that, I’d like to turn to guidance for Q3 2019. I want to start with our normal update to give transparency on our quarter-to-date performance. On a year-over-year basis, our Direct Retail gross revenue growth is running in the mid-30s thus far into the quarter, while this is somewhat lower growth than when we exited Q2. It is not uncommon for us to have variability in our month-to-month growth rate within a quarter. Our guidance setting discipline is to consider our quarter-to-date performance as well as our expectations for the full quarter and then prudently guide. As you’ve heard me say, almost every quarter in our mass market consumer business, the customer has to show up every day and there’s still a lot of the quarter to go. Given our typical approach, we are setting our guidance for overall revenue growth just below our current quarter-to-date performance. We forecast Direct Retail net revenue of $2.22 billion to $2.27 billion, representing approximately $525 million to $575 million of Direct Retail dollar growth year-over-year, or a growth rate of approximately 31% to 34%. For the U.S. business, we forecast Direct Retail net revenue growth in the range of 30% to 32% year-over-year and expect international Direct Retail net revenues to be up 40% to 45% year-over-year. On a constant currency basis, we’re forecasting international growth between 42% and 47% year-over-year. We forecast other net revenue to be in the range of $5 million to $10 million of total net revenue of $2.23 billion to $2.28 billion for the third quarter. We are not adjusting our current level of investments based on our revenue guide. As such, the U.S. business will swing to a loss this coming quarter. We continue to believe we are on the path to sustained adjusted EBITDA profitability for the U.S. business, but repeat, it will not be a straight line. And our current year breakeven levels of adjusted EBITDA in the U.S., even small changes can easily swing us to a gain or loss in any one quarter. For consolidated adjusted EBITDA, we forecast margins of negative 6% to negative 6.5% for Q3 2019, reflecting our ongoing investments in international, continued spend on advertising, where we are delivering our returns threshold. The timing of campus recruits joining Wayfair in the U.S., and the further build out of our global logistics network. In the U.S., we expect adjusted EBITDA margins of negative 2.75% to negative 3% and expect an international EBITDA loss in the range of $80 million to $90 million in Q3. In North America and increasingly in Europe, our investments are paying off in the form of greater scale and higher levels of repeat over time, which tells us our strategy of not timing our investments to any particular quarter is working as intended over the long term. We expect to stick to this philosophy and we will not alter our ROI positive long term investments to make any particular quarter more profitable. For modeling purposes for Q3 2019, please assume equity-based compensation and related tax expense of approximately $66 million to $68 million. Average weighted shares outstanding of $92.5 million and depreciation and amortization of approximately $53 million and $55 million. I’d now like to turn the call back to Niraj before we take your questions.

[Niraj Shah:]

Thanks, Michael. Steve and I are very excited about the growth of our business this year. The competitive advantages we continue to build on and the immense opportunities still ahead of us both in the U.S., and internationally and in mass and in luxury. Our growth is representative of the remarkable platform and experience we have worked hard to achieve, as well as the strong secular tailwinds from which we benefit. We’re extremely proud of the team of over 14,000 people and all of the initiatives they’re working on to make the customer experience as delightful as possible when shopping for the home online. We want to thank our employees for their hard work, passion and engagement, as we collectively strive to capture an out-sized share of the secular shift of home goods dollars moving from offline to online. I will now ask the operator to open up the lines. So we may answer some of your questions. Thank you.

[Operator:]

Your first question comes from Peter Keith from Piper Jaffray. Your line is open.

[Peter Keith:]

Hi, thanks. Good morning, everyone and congrats on the solid Q2 with improving KPIs. You’re just at risk of asking a bit of a short term question, Michael, the shares have turned down since you provided some of the quarter-to-date metrics. It’s obviously a lower trend and what investors are used to seeing and coming off the heels of strong advertising growth in the first half of year. Wondering, if you guys could provide some perception of what’s caused this recent de-sell and if you might expect any type of reacceleration of businesses that the months move forward.

[Niraj Shah:]

Hey Peter, it’s Niraj. Thanks for your question. Let me jump in and provide some thoughts and then Michael turn out – can chime in with any additional thoughts he has as well. Yes, so what I would say, first of all, obviously like when you mentioned we were watching the stock and the premarket or the growth in first month of this quarter, those are both very short term measures and if you look at our stock over time, you see it’s highly volatile. If you look at our business, when we grow at the rate we grow at, which is really the outcome of doing dozens and dozens of ambitious things, there’s inherent volatility. That’s an outcome of the way we choose to run it, which is what yields, sort of – in our mind, incredible success. And frankly, we can actually map it with the metrics we have internally. So the reality is that, growing in the mid-30s, for example, which is what we said quarter-to-date had been, last year, we had four quarters that all grew over 40% and in three of them we had a month that was in the mid-30s, for example. And that’s just sort of the reality when you’re doing dozens of things, each thing you do, you inject some volatility in the business, you do it for a good outcome. For example, we launched a great new app redesign this quarter that we’re really excited about. But when you do that, you reset some of the customer consideration cycle for a portion of your customers. Well, if you worry about that and you obsess about the space, you don’t actually move the business forward. But when you do it, but aggressively, you’re actually doing great things for customers, you quite really get outcomes. Here, we also have some volatility that’s imposed on us, frankly, in the sense of tariffs. Our business model is more resilient than that of traditional retailer by being a platform. We have suppliers who will win, suppliers who will lose, suppliers who will choose to run lower margin and take shares, suppliers who will choose not to do that. But that creates volatility. So the way we look at it. To answer your question, do we foresee acceleration? I do. When exactly will that kick in, I don’t exactly know. And if you look at our history and look at the way we grew over the years, we’ve had periods. That’s flowed little periods. That picked up a little, it’s usually on the outcomes of these big things we did. Like one big thing we’re doing right now is our logistics network. And that frankly, just it’s going great. And there’s a huge dividends that are going to come out of that. They come out over a period of years and we’re now keeping up into it. We were actually – we’re highly, highly confident of those gains. We’re actually seeing some of them flow through well as we get more and more volume through that network. We know what that will yield. Europe is another big expense that that’s providing great gains and FX frankly is the headwind, but we don’t worry about that. We’re investing aggressively. That’s part of the negative free cash flows. We’re investing aggressively in putting in place an infrastructure, logistics, our European business. So I’ll keep going. So I know, it doesn’t speak specifically to the few question you have about volatility and it’s measured in weeks, but that’s the way I think about it. Michael, do you have anything you want?

[Michael Fleisher:]

No. The only other thing I’d have, Peter, that I know you mentioned this sort of ad spend. I just want to remind everyone, we spend our ad dollars based on a one-year payback on a contribution margin basis. If we’re not getting that one-year payback on a contribution margin basis from the performance of those dollars, we know it quite quickly and we would ratchet it back. So there’s a clear ROI investment on every dollar we spend. We’re seeing it payback, where as continuing to see that performance in the cohort – our cohorts of customers. You saw that in the cohort chart we put out at the end of the last year and those cohorts have continued to perform, and that gives us a lot of confidence that the ROI metric and the investment we’re making in the ad dollars is really working.

[Peter Keith:]

Okay. That’s very helpful. Thank you, guys. Maybe if I get asked one other longer term question and just coming off the heels of your Q2 supplier events. So we continue hear very terrible commentary about Wayfair from suppliers. But one comment that started to resonate is that the Wayfair has so many new programs that suppliers do have a hard time keeping up or doing proper ROI analysis to justify some of the upfront investment. Is there any thought to slowing a supplier programs to allow for some optimization? Or maybe in turn making some of the interface user friendly and some of the data analysis for user-friendly?

[Niraj Shah:]

Peter, that’s a very, very astute comment you have. We internally have recognized for years, if you look at the website of app, that’s the platform, the technology platform. And we give to our end customers and if you look at the way in which we reduce friction and made it more and more intuitive and easy to use, even while adding tremendous amount of feature and functionality. If you’d look at that, man that’s really been quite amazing. You made it more powerful, more complicated in some ways and yet easier at the same time. And then if you looked at the technology tool step that we’ve used historically with our suppliers where we store, we call it the extranet and recently, which is I’m going to address, where we branded partner home. You’d say, well that really seems like a clunky set of over a hundred tools. And if you compare the two, there wouldn’t really be a good comparison. In our business, we’re a platform connecting these suppliers with these customers. You’d want totally different set of tools but equally powerful, equally friction free, equally elegant and you’d want to make each one more and more powerful while still making more and more easy. And so that’s something that we recognized a while ago where we’re about six to nine months into scaling up the team that’s going after it. And the plans are quite – we’ve been quite great. It’s not investment. We specifically called out, but it’s in the guidance that we’ve given you for headcount. So the costs are captured in there and we think it’s actually one of our biggest opportunities because we don’t think the answer is to have less and less tools and less and less programs. The tool – that the key is to make them easier for suppliers to adopt them regardless of the sophistication of the supplier from a technology standpoint. And increasingly, regardless of the size of the team the supplier has on the program, by making it easy for them to opt-in in a way that can be lighter and lighter from a workload standpoint, easier and easier for them to recognize the ROI. What we’re seeing is there’s huge enthusiasm on their part to participate. But frankly, that the complexity involved today is, one of the sources of friction that we’ve been eroding. And I think over the next, six, 12, 18 months, we’re hoping to transform that platform from what we have today to one that – but today, we’re still viewed as better than a lot of other platforms in terms of supplier tools. We think there’s a huge opportunity. We are going to compare it to what we offer consumers from that elegance standpoint.

[Michael Fleisher:]

Peter, it’s Michael. The only thing I would add there is. You spend a lot of time at markets. And so you recognize that there’s a very long continuum of suppliers sophistication level around how they think about and run and manage their own businesses. And so therefore their ability to take advantage of our business, Niraj was just talking about as all the investments we’re making make that easier and easier. But to some extent, this goes back to the very founding of the company, right? But from the very beginning, we’ve been educating and working side by side with suppliers as our partners to sort of teach them how to take advantage of what we’re building. And so at any moment in time, right, whether it’s sponsored uses or just sort of how to have inventory on hand at CastleGate or whatever it might be, there’s a constant dialogue with all of our suppliers to sort of bring them along, both with the tools they need to sort of manage it every day, but also to help them think about what their business has to become in order to take advantage of our opportunity.

[Peter Keith:]

Okay. Thanks a lot guys. That’s great feedback. Good luck with the back half.

[Niraj Shah:]

Thanks Peter.

[Operator:]

Your next question comes from Maria Ripps from Canaccord. Your line is open.

[Maria Ripps:]

Good morning and thanks for taking my question. I appreciate the color on international business. So maybe you can spend a few minutes talking about potential international expansion outside of the existing market. So what kind of operational milestones would you like to see within your existing international geographies for you to get more comfort around expanding to maybe some of the adjacent markets and is it a near term priority for the company?

[Niraj Shah:]

Thanks for your question, Maria. So here is the way we think about it. In North America today, we’re very focused on the U.S., and Canada and we think there’s still a lot of room there, despite the fact that we built a brand with top of mind awareness and where we’re well known. In Europe, we started in the UK and we’ve organically over time become the leader in the UK. And the brand awareness is now reaching household brand status. It’s not quite there, but it’s quite close. And then earlier this year, we started focusing on the German business a couple of years ago, but earlier this year we started the brand building in Germany. We referenced the television advertising that we launched and Barbara Schöneberger is our spokesperson. Well, what we want to see happen next, which is happening is we want to see the German business following the same footsteps and we’re able to time index these countries in the KPIs that when start the marketing at different milestones along the way to make sure that we’re seeing the same customer satisfaction. The same repeat performance and all the types of metrics that we know drive the long term outcome. And what we don’t want to do is expand further in Europe in a way that we have many different markets that are all still early stage where it distracts us. What we want to do is make sure we do it in a very methodical way, but we will plan to expand further in Europe over time. But the focus right now is on Germany. And Germany is going quite well. And so if it continues going quite well, which is what we would expect, there’ll be a point in the not too distant future, we will figure out what the next sort of adjacent or obvious European market to tackle would be, but we’re not in a rush and we don’t have a fixed timeframe for it. It’s rather based on this kind of continued kind of focus and continued success. With the UK and Germany, we address about half of the GDP in Europe. So even though it’s only two countries, it’s a meaningful portion of the market. And then the thing that I would point out is that the cost, when we talk about the investment in Europe or the investment in logistics, they’re really big, part of it is because we’re planning for the long term outcome. On the logistics side of things, like Asia consolidation, what we’re doing in ocean freight and drayage than what we’re doing in the warehouse and what we’re doing with the home delivery and it all adds up. It’s quite expensive. Well, Europe is similar because we built a Pan European Networks. So today, we sourced from over a dozen countries throughout Europe and we have a transportation network that pulls those items, brings them into the markets where we then do the home delivery, which today are just the UK and Germany, but the infrastructure we built to handle taxation, to handle transportation, to handle customer service, to handle language translation that will make it actually not as difficult for us to enter additional markets. It’s not that there’s zero complexity, but there’s far less than there would be otherwise. We have category management teams that are based out of our office in Berlin, but that’s focused specifically on markets in Italy or Spain or Poland, that are native language speakers and native of those countries. And so we were actually – and we think an advantage position for our long term European plan with cost we’ve already incurred. But in terms of where we’re going to focus on building the business right now, it’s just the UK and Germany.

[Maria Ripps:]

That’s very helpful. Thank you.

[Operator:]

The next question comes from Brian Nagel from Oppenheimer. Your line is open.

[Brian Nagel:]

Hi, good morning. I want to go back to if we could and I apologize for that kind of the shorter term nature of the question, but just the guidance Michael and the sales slowdown, modest sales slowdown we’ve seen here thus far in Q2. But having followed way forever while now, your company, your ability to track your consumers and you know your consumers is better than anyone I’ve ever seen. So the question I have is, as you look at what seems to be a deceleration sales from what Q1 to Q2, is there any more color you can give us on the metrics, the KPIs you’re looking at that could help us understand the real genesis of this? And then so that we can maybe understand better frame, better whether this is indeed transitory short term in nature versus some type of a longer term slowdown?

[Michael Fleisher:]

Yes. Thanks, Brian. Nothing is changed in a substantive way in the broad customer set KPIs and I think you, by the way, the place, you see that pretty clearly in the Q2 results, right on every KPI metric in Q2, we basically hit a new high. And so the way that cohorts are performing, the way that customers are performing, their purchases, all of that remains quite strong. I think Niraj pointed to a couple pieces that could well be factors in this sort of first month of the quarter, right, introducing a new iOS app, it’s the kind of thing you do that there’s no way to detest it. You do it because it’s the right news for customers over the long-term. But as we pointed out last quarter, our app is now – have a more substantive group of our customers running through it every day, right. And so if you changed their purchase path, that’s going to have some near-term impact. As we take the supplier tariff price increases and put them into customer prices, that’s going to change the purchase timeline and process for a customer. And so I think there’s a couple of those kinds of sort of short-term factors out there that I think could clearly be impacting this first month of the quarter. And as Niraj pointed out, we certainly had quarters with months in the mid-30s before that ended up at a higher place. But I think the other piece of it, Niraj talked about earlier is this level of volatility at this scale, this growth rate, this level of volatility and the number of investments we’re making, this level of volatility should be expected, right. We are going to have months or quarters that are slightly slower growth, and months or quarters that are slightly higher growth. And I think trying to call that to a couple 100 basis points is going to be really hard.

[Niraj Shah:]

The only thing I’d add to that is, the app – we’re excited about the app. It’s one of dozens of things that we did in the last quarter that inject volatility. That’s meant to just be an illustrative example. And so those things can create some volatility. Then you have external volatility, which for example could be macro, it could be tariffs, could be things like that and you net out these numbers. So when we need guide, we’re guiding here it’s August 1, so we have literally one month of data or three months of the quarter. And so we just used whatever we have. We tell you what’s happened so far and we just use that to project it going forward. So we don’t actually say, well what do we think exactly will happen in the next two months? Because the challenge with that is the timing on these things is never that precise. And so, certain things we’re seeing today, last 30 days, 60 days, 90 days, 120 days, it’s very hard to tell. And so what we do is we just tell you the current to date because that’s a fact base we have and then we just sort of build up guidance around that. But the reality is, as you’ve seen with the business, business has some inherent volatility that we inject in it because of the sort of ambitious nature we have, which is why we’re getting great outcomes. But we sort of don’t let that very short term volatility, which is higher than you would have if you only grew 2%, 4%, 6%, 8% a year or something, lower like that. We don’t let that affect how we make good long-term decisions.

[Brian Nagel:]

Got it. Thank you. If I may follow-up on separate subjects. So Niraj, you spent a lot of time talking about your proprietary distribution infrastructure, which is obviously a key component of the power of the Wayfair model. As we look at the ongoing build out, how should we think about the duration? How far particularly with the domestic market, how far are we into the build-out? And then maybe for Michael, with this build out and we look at the expense growth, obviously there’s a lot of investments happening at Wayfair. But what portion of that investment spend relates or pertains directly to the build out of this distribution infrastructure?

[Niraj Shah:]

Sure. I mean the distribution infrastructure is an expensive piece of our cost structure today because as we built out locations and we have a campus in Kentucky up by Cincinnati, Ohio, we have a campus in New Jersey, we have buildings in Atlanta and Dallas and campus in outside of LA. But then we’ve added, we just added a building in Savannah and we have two more coming in the not too distant future in Northern California and in Jacksonville. And so today the utilization of the network is not anywhere near the full capacity. We’ve been building up this corporate, but the footprint we largely have built out. So what happens is you get the gains as utilization rises in the building and as you do that, you basically create a staffing model so you can work three shifts and you can basically really take advantage of the speed opportunity and get more throughput through the buildings. We recently, for example, moved to a three shifts to a seven day a week model with multiple shifts. And what that basically does is that increases our cost base, it actually makes the per unit cost drop at a certain utilization level. But that’s never the day you shift into it. So we actually just – that’s an example of something we just did recently, it’s actually really – from online it’s fantastic and speeds up delivery, it increases what your throughput through the building can be. So over the next – it’s hard to take back timeframe on it, but so you think broadly over the next couple of years what happens is you’re really driving volume through existing buildings more than adding buildings per footprint coverage. You generally are adding buildings more for volume needs and your mass aren’t maximize your older buildings and throughput, which is making your costs per unit drop and you’re also reducing transportation costs as you do it. So to answer your question in terms of the build out, we will be building a more buildings, the answer is, yes. Will the profitability of buildings we build in the future be much higher, it will be yes, because we won’t be building them until we actually need a space and sort of timeline when utilized space shrinks dramatically from where it is today.

[Michael Fleisher:]

Let me just add a couple of thoughts on the sort of cost that set of investment. I think you think about the logistics network build out as having an impact from a cost perspective on both – on all three lines, right, gross margin, OpEx and CapEx and just to try like dimensionalize. On the gross margin side, just use the example of moving to a seven day model – operating model. The place we see that right is that you’re then going to sort of operate for a short period of time, so these are going to operate less efficiently, right? And so the place you see that is in the COGS line, right? Because that’s the piece that we’re sort of running through as a cost of goods sold in terms of the delivery costs. On the OpEx line today, we barely unutilized rent of warehouses that we built that are not fully utilized. And today that number is in the sort of range of $15 million to $20 million a quarter. And then on the CapEx side, right, you can see this quarter we spent $54 million in PP&E CapEx. A big portion of that spend is the CapEx going into this warehouse network, right? And when you think about how the free cash flow of our business has changed, right, last year – first half to this year, first half. And there’s two big investments that we’ve made there, right. One is the continuous losses and investment in the international business and the growth of that business. And then the second is the capital cost, right? The CapEx cost that we put in, particularly in the logistics network. And I think as Niraj mentioned, we continue to build that network in advance of the coming volume, right? So you have to stay at the head of it or on top of it. But that’s how I would dimensionalize the sort of the investment places where the dollars are going to build out the logistics network.

[Brian Nagel:]

Great. Thank you very much for all the color. I appreciate it.

[Michael Fleisher:]

Yes. Thanks, Brian.

[Operator:]

The next question comes from Oliver Wintermantel from Evercore. Your line is open.

[Oliver Wintermantel:]

Yes, thanks guys. I had a question regarding – so the order from repeat customers continue to grow faster than the orders from the new customers, which probably helps your margin and U.S. revenues also grows faster than what you guided to, but the EBITDA is basically in line or slightly blow. Could you give us some details, why that EBITDA is not reflecting a lot higher due to the revenue growth?

[Michael Fleisher:]

Hey Oli, it’s Michael. So I think the thing to remember is that we are – and I try to say this every quarter, right? We continue to spend in any quarter based on the long-term investments we’re making in almost every one of our line items. And so, if our marketing team finds the right advertising opportunities and can spend within our payback threshold, this ROI, those hard ROI thresholds, we’re going to spend those dollars and get those new customers. Because we know that they’re continuing to perform as a new cohort better than the last previous year’s cohort. Same thing when you think about when we’re going to go open a new facility or hire a new person, we’re going to make those determinations time to what we think is the right long-term answer to build our business and serve our customer as opposed to, are we going to sort of make more in this quarter or not. And so in any quarter and I just described it – as we described our Q3 guidance, what we’ve got planned to spend this quarter based on what we think those we can do in the ad markets and get our ROIs, is except we know what we’re going to do. It will move as we start to see what performance looks like. But if revenues a little higher, a little lower, we’re not going to sort of change the investments we’re making for the long-term.

[Niraj Shah:]

Oli, Niraj here. Couple comments, I just chime in on. One is if you look at the way we’ve sort of inform that calculation, if you look at repeat it running at 7% you’ll see that the customer acquisition cost still hovering in that same range $50-ish and you can see how the paybacks are staying very tight because actually the repeat economics are getting stronger. And so the ad cost is done in very disciplined way. But on the EBITDA line you have a couple other things that drive that in the near-term. One is I mentioned like for example, some of the things we’re investing in on the logistics side, like the seven days a week. Like those things have some costs, but that yield could benefit again, not in the current quarter. And then Michael did reference a movement where we’re increasing running infrastructure in the cloud. And so if you look at from a cash flow standpoint, that’s actually going to be a very good trade for us. But the reality is, it’s moving money out of what would be in depreciation into OpEx. And so we’re not going to worry about the optics of that. But the reality is that’s going to – if you’re looking at adjusted EBITDA, it’s going to weigh on that. But the reality is what we’re focused on is how the company will become incredibly positive on a free cash flow basis. That’s what we’ve always wanted for, so that’s why that’s a good trade. So there’s a number of things in there.

[Oliver Wintermantel:]

Got it. Thanks. And just quickly, Prime Day this year and July was longer than it has ever been. Have you seen any difference there from your customers, trade away from you guys? Is that why the quota today to avenues could be a little bit weaker as well or do you think that has nothing to do with it?

[Niraj Shah:]

We don’t think that has much to do with it. Because in fact, we see as things like Prime Day become retail holidays for everybody. They become good days for all retailers out there. In fact, there’s some public data showing Walmart, target number of others did on Prime Day. You can see that Prime Day is actually a boon for everyone. We saw us like very similar on Way Day, were Way Day became a – we like this because Way Day is obviously named after Wayfair were the leading marker of it. But a number of other major retailers ran home shopping events on that day and a half period. So I think some of these things just become major retail holidays and the way that Singles’ Day has in China. And I actually think that they’re on net, they’re sort of good for everyone in a way that has Cyber Monday or Black Friday.

[Oliver Wintermantel:]

Thanks very much. Good luck.

[Niraj Shah:]

Thanks, Oli.

[Operator:]

And our final question for today will come from John Blackledge from Cowen. Your line is open.

[John Blackledge:]

Great, thanks. Two questions. On logistics just curious what percent of revenue or units are running through CastleGate at this point? And as you invest in and build it out, how does it drive the customer value prop on competitive moat? And also is it being built in a way that you can increase the speed of shipping to next day at some point similar to Amazon’s recent move to a Prime One-Day. And then on the growth margins expanded nicely this quarter. Just wondering about the impact of the advertising business this quarter and then how we should think about it kind of ramping in the back half of the year. Thanks.

[Steve Conine:]

Thanks, John. Let me answer a couple of parts of that and then I’m going to defer to Mike on one part. On the logistics network and the speed, the nice thing, if you think about the places that we have operations and the way in which we’re running it, seven days a week, we’re in multiple shifts. We actually, that network automatically becomes a one day and even as same day network as more and more goods are positioned into more and more facilities. And a lot of what we’re doing with Asia consolidation and the like basically enables that. And the real benefit is that frankly, it’s scale – it’s actually less expensive than a two day network, because you’re basically positioning goods ahead of time, very close to the customer. So you’re basically using a leg of transportation that’s the same, but you get it closer so that the last mile leg is shorter and smaller and so it reduces your net total costs. And so that’s something that we’re – that’s been part of the vision for a very long time. We believe speed is critically important in every category of goods. On the gross margin question and the advertising, I just want to – on the advertising, we’re very bullish on it, but I just do want to highlight, it’s still quite early and it’s still quite small. So I wouldn’t focus on the advertising businesses really being a major driver at all of the financials today. However, we do think that offers great opportunity in the future for upside. And we’ve been very cautious not to put a timeframe on that because it will play out over time. And it’s not something that we think of the light switch. On the CastleGate penetration, I don’t recall the last public numbers we gave, so I’m going to let Michael answer that one.

[Michael Fleisher:]

Yes. The last numbers we gave was 26% of U.S. small parcel that was back in Q4, was running through CastleGate. And then in Q1 we talked about 14% of large parcel running through CastleGate. We continue to make progress there. It’s not a number we’re going to update every quarter. But I do think this from your own conversations, I know with suppliers, they’re adopting, they continue to adopt and as we get more and more efficient in sort of giving them good forecasts, their ability to sort of run more through that network is really enhanced. And then the other thing that I always point out on this sort of notion of a penetration is, our whole business is growing so fast that growing penetration in those means that we’re growing the inventory on hand. And so that piece is really important to recognize that. Over the last few years we’ve gone from not having this program to having 26% of small parcel running through it. And you think about the amount of growth of inventory that suppliers are now putting into our building. It’s actually really stunning off balance sheet path for us, if you will, because you have all of that inventory basically with your ability to get it to your market and get it to your customers very quickly, but without having to deploy that capital. And that’s really sort of an amazing underpinning of our business model.

[John Blackledge:]

Thank you.

[Michael Fleisher:]

Great. Thanks, John.

[Niraj Shah:]

Yes. Thanks, everyone. We appreciate your time.

[Operator:]

Thanks everyone for joining us today. This concludes today’s conference call. You may now disconnect.