Excerpted from an email which Whitney Tilson sent to investors this afternoon.

An interesting bull-bear debate on Wayfair going on. Below is the upgrade from yesterday and Xuhua Zhou’s response today.

I’m strongly with the bears (and am short it).

PS–Some of the comments on the message board below Xuhua’s article claim the following:

it’s almost impossible to replicate someone’s search results. That’s why it’s a bad metric to base your opinion on. Search results vary by location and IP Address, past google search click history, etc.

However, I just tried more than a dozen search terms in which the Google rankings Xuhua found for Wayfair were much lower than what the BofA/ML analysts found, and every case was consistent with what Xuhua reported.

Sell Wayfair When Negligent Wall Street Analysts Are Too Lazy To Google

Xuhua Zhou

Hedge fund analyst

Sep. 9, 2015 9:25 AM ET  |  8 comments  |  About: Wayfair (W)

http://seekingalpha.com/article/3497666-sell-wayfair-when-negligent-wall-street-analysts-are-too-lazy-to-google

Disclosure: I am/we are short W. (More…)

Summary

Sell-side research analysts misstate Google search results.

Low repeat rate will drive continued advertising spending and destroy EBITDA margins.

Highly frequent insider selling adds pressure.

Inventory-light model raises questions over product quality assurance.

Just when I thought the bear case for Wayfair has become crystal clear that no sell-side research analyst would even entertain defending the stock, BAML analysts Paul Bieber and Justin Post proved me wrong. In a note published on Monday, the pair of research analysts upgraded the stock from neutral to buy, despite slashing their price target by 17%. Furthermore, a substantial portion of their bull case rests on Wayfair’s high placement in organic search results on Google for home goods. But did they properly Google the keywords they claim to have Googled?

“We performed 50 searches on Google for home goods and our analysis indicated that W was the #1, #2, or #3 organic search result 80% of time”. Unfortunately for investors heeding the opinion of the pair of analysts at BAML, they did not seem to perform the Google searches they claim to have performed. Of the random 50 sample search phrases the analysts claim to have Googled, 25 were ranked #1 for organic search results on Google and 11 were ranked #2, according to them. I performed identical searches of the key phrases in Google and received a set of completely different results. Now, there are two possibilities here: it could be that the BAML analysts did not bother erasing their cookies before conducting their little exercise, or it could be that they did not even bother actually doing the searches on Google. Either way, the factual error undermines their credibility, as investors would reasonably expect internet research analysts to understand that Google uses cookies to customize search results.

Of the 23 items ranked #1 by BAML, only 7 items are actually #1 when searched on Google, with the rest all ranked lower. “Table linen”, for example, is ranked #6 even though BAML claimed it is #1. Of the 11 items ranked #2 by BAML, only 1 item was actually ranked #2 on Google, with the rest all ranked lower. “Dinner plates”, for example, is ranked #5 as opposed to #2 claimed in BAML’s research.

Whitney Tilson Wayfair

Whitney Tilson Wayfair

Whitney Tilson Wayfair

For a complete reference of Google search ranking of key phrases used in BAML research, see the chart below.

Whitney Tilson Wayfair

Oftentimes, sell-side analysts have different points of view that are subject to debate. As stretched as the merits of their argument might be, the points are, at a minimum, based on facts. Organic Google search results are not subject to debate. Before recommending your clients to get into a money-losing e-commerce business, at a minimum, make sure you have conducted correct Google searches.

Cohort Analysis

To analyze a business model such as Wayfair’s, access to proper cohort data will help investors understand whether the company’s business model and brand are indeed gaining grounds with customers. Analysts have gone to great length to highlight repeat purchase behaviors at Wayfair. No bull thesis stands without assuring investors that the company will be able to retain customers after it turns off the tap on advertising spending. Unfortunately, with the exception of its IPO prospectus, Wayfair seems to have been trying hard not to disclose a proper set of cohort data that will show the percentage of repeat customers over time.

Whitney Tilson Wayfair

Instead, Wayfair management and sell-side analysts have been actively promoting two sets of seemingly similar data points, hoping investors might simply equate those to proper cohort data.

Almost always, when management actively hides readily available data and direct investors’ attention to data that look alike, there is something under the hood that is worth digging. In the case of Wayfair, it is important to explain why seemingly rapidly improving data points offered by management do not translate to sufficient improvement in customer retention.

Company management likes to point to a PowerPoint slide in its investor presentation deck showing rapid improvement of its gross revenue per customer over time.

Whitney Tilson Wayfair

On the surface, it looks like an impressive achievement showing customers acquired in more recent period spending more over time than customers acquired in older periods. Management further highlighted that in the 6th month post initial purchase, average 2014 customers spent over twice as much as ones in 2011.

First of all, it is a fairly confusing set of data. To calculate the average spending during the 6th month of initial purchase of customers acquired in a specific year, Wayfair has to track July spending pattern for customers acquired in January, August spending for ones acquired in February, and so on and so forth until it aggregates December spending for customers acquired in June. If you assume a constant order size and a constant percentage of 6th-month repeat customers, the disclosure really provides a snapshot of repeat customer rate in the 6th month post initial purchase relative to prior years.

Going back to the repeat customer definition in Wayfair’s prospectus, the company defines a repeat customer as someone who purchased from the same site at least twice during the quarter and the subsequent 270 days. In another word, a repeat customer is the cumulative probability of someone who bought again in either the 1st month, the 2nd month or 3rd month etc., up until the 9th month after his initial purchase. For the more mathematical minded, think of the repeat customer percentage as a bell-shaped cumulative probability function, with each further month representing a smaller percentage of the repeat customer percentage. This is also easy to understand, because over the span of 9 months, a repeat customer is much more likely to purchase in the first month of their initial purchase rather than wait till the 9th month to make a repeat purchase.

Wayfair disclosed in the third quarter of 2011 and 2013, repeat rates were 15.9% and 24.2% respectively. Due to the way repeat customer is defined, 1st-month and 2nd-month gross revenue per customer over time is likely a better proxy to assess the repeat rate trend. A rough bootstrap of years 2011 and 2012 (data from the 3rd quarter of 2011) for the first month yielded roughly 9.5x, and in the years 2013 and 2014 yielded roughly 15x. The percentage increase also corresponds to Wayfair’s reported repeat rate increase from 15.9% to 24.2%. If one were to perform a similar calculation, the company’s repeat rate in 2015 so far is likely right around 30%. Now, sell-side analysts like to compare Wayfair against other similar players in e-commerce – a 30% repeat rate should warrant a significant discount relative to peers. At a $2 billion-a-year run rate, if Wayfair still manages to lose 70% of its customer after acquisition, its long-term viability is severely questionable, as the company may never be able to turn off its advertising spending.

Oftentimes, investors find it difficult to navigate companies with obviously flawed business models, yet seemingly improving metrics. When Angie’s List and Zulily were skyrocketing on improving metrics, fundamental flaws in their business models often get cast aside as sell-side research analysts cheerlead quarterly improving metrics as proving a successful business model. Nothing can be further from the truth. Oftentimes, in the case of flawed business models, a temporary improvement in metrics have explanations unrelated to business model validation. My note on flawed cohort analysis in Angie’s List should serve as an alarming bell that overly relying on sell-side interpretation of improving metrics could likely spell disasters down the road.

Insider Sale

While much of the bear case on Wayfair has been extensively discussed, one thing that has yet to garner much attention is the pattern of insider selling at the company. Its founders and executive team members are among the most frequent insider sellers I have ever seen. The 10b-5 trading plan of its senior executives and founders provide monthly selling in excess of 135,000 shares. What makes Wayfair’s case more interesting than others is the fact that every single member of its executive team seems to be engaged in the monthly trading plan, even ones who own relatively small amount of the stock. The trading plan makes Wayfair a more attractive candidate for short selling, due to the constant addition to free float. With the Labor Day holiday behind us and sell-side research pumping out bullish notes, a secondary offering is likely imminent.

Conclusion

Wayfair has an indefensible business model. Spending massive amount of money to buy traffic is a losing proposition when you cannot afford to compete on price with Amazon in high-volume merchandise. With investors being blinded by growth in a low inflation, low interest rate environment, less thought is given to the fact a $2 billion revenue business should not be posting negative EBITDA unless it has fatal flaws in its business model. I struggle to find another viable consumer retail name that posts negative EBITDA at such scale of revenue. Wayfair’s inventory-light model dictates that the company lacks control over what is shipped to its customers and sufficient assurance over the quality of its products. I would like to leave my readers with the review posted by Chelsea of Wayne, PA, after she purchased a wine rack from Wayfair. Although an isolated incident, it speaks to the fundamental issue facing the company as it continues to grow. Just as vendors praised Wayfair, consumers are not necessarily dealing with the best products when they buy from Wayfair.

“My boyfriend sent me this as a housewarming present. I was extremely excited to open it. We opened the box when it arrived and when we pulled out the wine rack from the back, out came a decaying mutilated body of a cat. It was honestly one of the most traumatizing things I’ve ever seen. My whole apartment smelled like decaying flesh. I don’t know how that happened but dear lord you guys need to check your packaging because it was horrific.

When we called the company they offered us 25% off our next order… thanks, I guess? If that’s how you deal with sending a customer a dead animal in their package, you all need to seriously rethink your customer service. I do not think I can ever order from you all again and I am telling all my friends and family about it. Supposedly you’re sending me a new wine rack, I’d appreciate it if you check the box for animals before sending. To all that think this review is a joke, unfortunately it is not. I hope this NEVER EVER happens to anyone else.”