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1. Wayfair: Pricing Strategy & Gross Margin

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Wayfair Pricing Strategies and Gross Margin

“Over the last 4 or 5 years, we’ve had this agenda on how we can unlock a lot of gross margin. We're talking about a 1,000 basis point runway, and this was back when we were at 24% to 25% gross margin.” - Niraj Shah, CEO of Wayfair, Q3 21 earnings call

We’ve been studying Wayfair to understand the company’s long-term opportunity and potential mature gross margin level. For the nine months to September 2021, Wayfair’s gross margin was 28.8%. This is an increase of half of the 1,000 basis point improvement that Wayfair targeted in 2016.

We believe the gross margin is one of the most important metrics to follow because Wayfair accounts for supplier service revenue (such as CastleGate fulfilment, drayage, advertising, etc) as a contra-revenue item which shows up in the gross profit.

Wayfair’s gross margin is driven by four key components:

1. Lower product cost

2. Improved pricing and lower merchandising costs

3. Logistics cost savings

4. Supplier services revenue

Over the last month, we’ve interviewed executives to explore each pillar and will discuss what we have learned over the coming weeks.

Firstly, we interviewed a former executive in the Pricing Strategy and Analytics team at Wayfair. The executive worked closely with Niraj to define the pricing model that sets the gross margin for each individual SKU.

Wayfair’s approach to pricing is a great example of how the company is far from a traditional retailer. Historically, on the product side, retailers are organised into two teams: buyers that procure products directly from suppliers and merchandisers that place and price items in the store.

Buyers haggle with suppliers to receive the lowest possible price and merchandisers typically add a fixed margin to the landed cost the buyers achieve. This is the standard cost-plus pricing model. If products don’t sell, discounts are applied until inventory is cleared. Although discounting is less of a problem for made-to-order furniture, incumbent retailers typically adopt a similar cost-plus pricing model.

Wayfair is very different; pricing is a global, standalone function:

"What is interesting and important about Wayfair’s pricing structure is that, first and foremost, it is important to note that pricing is a separate and distinct central function. The pricing for products is not managed by a supplier relations team, the product team, the merchandising team or anybody else. It is a centralized, global algorithmic pricing team that prices products based on relevant data inputs and estimations that are available to them, across the business."

There is no one person picking a margin level for certain products. Wayfair algorithmically prices millions of SKU’s in real-time. This was Wayfair’s CEO in Q3 2021:

"The way we do pricing, I think, is different than the way most retailers do it in the sense that we don't have individuals who are picking margin levels for categories or subcategories. Instead, what we do is we have a large data science model, and it is basically figuring out what tranches of the catalog to set at what margin levels. And it does it off the concept of really understanding consumers' demand response to pricing changes."

Wayfair’s pricing algorithm is based on three components:

1. Cost of goods sold

2. Price elasticity of demand

3. Market pricing

Cost of Goods Sold (COGS)

The COGS includes the product cost and other variable costs such as inbound and outbound shipping, fulfillment, damages, and returns. On average, 70-80% of COGS is the product cost, ~15% is fulfillment, and ~5% damages and returns.

Wayfair will programmatically estimate each component to calculate a fully-loaded COGS for each SKU. The algorithm then adds a markup based on the optimal margin profile for the item.

For example, if Wayfair is selling a sofa with a $1,000 fully loaded COGS and a 30% target gross margin, the markup will be $430 with a retail price of $1,430. The markup will change as the cost inputs and demand for the product changes.

Estimating each COGS component in real-time is tricky. Inbound and outbound shipping costs includes a forecast on shipping rates, middle-mile trucking costs, last-mile costs, and even an estimation on the end customer’s location. Inputs can change daily based on ocean freight or last-mile carrier capacity, both inputs that are out of Wayfair’s control.

The lack of visibility into the drop-shipping supply chain leads to more uncertain cost estimates and increases the difficulty to set the optimal gross margin.

This highlights the value-add of CastleGate: Wayfair controls more of the cost inputs, reduces the breakage and return rate, and can see where the product is at each stage in the supply chain. This drives lower product costs that are passed back to customers which drives higher turns for the supplier and more sales for Wayfair. It’s a winning solution for everyone.

The visibility of CastleGate items increases availability and reduces delivery times. Wayfair’s pricing algorithm places CastleGate products at the top of the search and at cheaper prices. Just like Amazon Prime products, CastleGate items have higher sales velocity than drop-shipped products:

"I would guess that the CastleGate conversion is, on average, over two times non-CastleGate conversion but it probably varies a lot by product. We know that the fast delivery promise itself is a huge conversion lift. A product that has a fast delivery badge has a 50% higher conversion rate, ignoring any other benefits, such as lower damage rates and other things that I mentioned."

Similar to Amazon Logistics, CastleGate is Wayfair’s attempt at gaining more control over the flow of inventory throughout the supply chain. More visibility into the supply chain enables Wayfair to drive higher product cost savings which are reinvested into lower prices to fuel greater volume growth.

Price elasticity of demand

Once Wayfair has estimated the fully-loaded cost, the optimal markup is based on product-level customer behaviour, delivery times, seasonality, and many other variables that impact demand of the specific product. This is the real difference in how Wayfair prices relative to offline competitors.

Wayfair sees $15bn of furniture transaction data. This is fed back to suppliers to optimise production and can be leveraged to optimise the retail price. This leads to customised optimal margins for each individual SKU that are adapted in real-time.

The most interesting part of Wayfair’s pricing strategy is that the whole system is engineered to increase the price inelasticity of demand:

"Wayfair measures product elasticity and this can change for every single product. It varies over time; it varies by time of year, with seasonality and things like that. As a result, each product has its own customized margin profile. The idea is that prices become more inelastic, over time. That means that margins should increase over the long run and that is the result of all the investments that Wayfair is making into its overall business model, to make customers sticky and more loyal to the Wayfair platform. That is really what is at the heart of Wayfair’s strategy. Those investments in supply chain, merchandising, selection, availability, service, all translate into customers being willing to pay more for a product they see on Wayfair’s platform."

Wayfair’s investments in greater selection, CastleGate to improve availability, WDN and ISC to reduce breakage, and better imagery and merchandising tools, all aim to build the best home shopping experience globally.

Wayfair believes it can build a superior shopping experience which drives customer loyalty. More repeat buying will translate into higher inelasticity of demand. The whole business is engineered to drive loyalty.

Competitor Pricing

The third component of the pricing strategy is scraping market and competitor pricing to ensure Wayfair’s price is competitive. This isn't too differentiated to offline players although it's done in real-time, programmatically rather than by a human.

The unbranded nature of the home category works in favour of retailers because it’s difficult for customers to perfectly price compare. This gives retailers more flexibility to adapt price to manage the target gross margin.

Although Wayfair still needs to accurately estimate fully-loaded costs and price elasticity, greater visibility of the supply chain will increase Wayfair’s control over the gross margin:

"Wayfair gets to decide the markup it charges on a product and, going back to what we talked about earlier, it’s not the supplier relations team and it’s definitely not the supplier that sets the price. This gives Wayfair a tremendous amount of flexibility and latitude in controlling its destiny, in terms of gross margin. Wayfair can decide where it needs its gross margin to be and what trajectory it wants that number to be on."

Because suppliers drop-ship or forward position inventory in CastleGate, Wayfair doesn’t even own the inventory it’s pricing. On average, the company runs at only ~2-days of inventory. It's closer to a marketplace than a retailer. Minimal inventory ownership also means that discounted prices don’t typically hurt Wayfair’s margin:

"the discount doesn’t necessarily have to come out of Wayfair’s margin. It is often a supplier-funded discount. In the case of the sofa we were talking about earlier, with a fully-loaded cost of $100, let’s say Wayfair’s supplier relations team convince the supplier to provide a $20 wholesale discount on that product. That means that Wayfair can then decide to pass that discount through to the customer and charge something like $123 for that product, whilst maintaining its full profit margin."

Each part of Wayfair’s system is structured to provide the best shopping experience which drives loyalty. If Wayfair can provide the best shopping experience, the platform is in a great position to also control the value it captures in the transaction. Whether this is from increased supplier services, lower COGS, or higher markups, it seems Wayfair has room to achieve the 34-35% mature gross margin Niraj targeted 5 years ago.

So what is the biggest risk for Wayfair?

"I think the fundamental risk would be, going back to the pricing model, that Wayfair’s customers were not as sticky or loyal as they thought, because they were not able to capitalize; the prices did not become more inelastic and margin did not go up. What that means is, customers may not have cared whether they bought their product on Wayfair or Amazon or somewhere else."

It comes back to the core driver of the business: the repeat buying rate. A lower repeat rate suggests demand is more elastic and Wayfair has to continually acquire new customers. This could break the economics. We estimate the cost of reactivating an existing customer is ~$17 compared to $50 for new customers.

So what drives the repeat rate?

Every small detail of the home shopping experience: more selection, better availability, great delivery service, attractive merchandising and imagery, effective pricing, etc.

Wayfair aims to redefine the way consumers shop for their home. The question is whether enough consumers wish to adopt Wayfair’s experience to make it profitable:

"I think the jury is still out on how customers shop. When you shop, do you go into Google and type in ‘sofa’? A lot of searches start on Amazon these days. The bet here is that, as people do on Amazon, they will start their search on Wayfair, for home. That means they are insensitive to the price; they love Wayfair and that’s where they want to shop for home. But whether that will actually be the case, given that it is an unbranded category, that is the biggest risk and that remains to be seen."

Over the next 2 weeks, we will publish and discuss our learnings from interviews on CastleGate and Wayfair’s supply chain.