“It seems to us that the basic building block of internet retailing, its skeletal structure, is far more robust, scalable and cheaper than the high street equivalent.' - Nick Sleep, Nomad Investment Partnership Interim Letter, 2007

This quote by Nick Sleep is always in the back of our mind when we’re studying internet retailers. When looking at new categories moving online, we question whether the building blocks of an ecommerce model are more durable than incumbent brick and mortar retailers. For example, does an online furniture retailer have an outsized chance of owning more market share than a traditional retailer?

We interviewed a Former Global Head of Fulfilment Engineering at Wayfair to explore how Wayfair solves the problem of delivering furniture online and why a potential solution could create a competitive advantage over traditional retailers.

Wayfair is not a typical furniture retailer. In fact, it’s possible that framing Wayfair as a retailer is completely missing the point. Consider this quote from our interview:

“At one point, there was a conversation around turns which, in any other fulfilment world, would have been topic one. It was verboten in CastleGate; initially, we did not talk about turns. The reason being that it’s the supplier’s inventory; it’s not ours, as Wayfair. It is their decision what to do with it and we’re not going to force them to turn it because it’s not that type of relationship. It’s a different model from the one Amazon has.” - Former Head of Global Fulfilment Engineering at Wayfair

It’s rare you find a retailer that is not laser focused on turns. However, the quote is less surprising after considering Wayfair's history.

Wayfair started as hundreds of standalone SEO-optimised websites offering every individual category of furniture. Each website was effectively lead generation for third-party furniture manufacturers who didn’t have the expertise of selling direct-to-consumer.

One aspect of home furnishings is that the vast majority of the category is unbranded goods which makes it difficult for customers to find products they want and even harder for suppliers to sell DTC. This sparked the original insight of creating Wayfair: by merging all the websites into one brand, it could aggregate demand online and build loyalty with customers.

Between 2002 and 2011, the business was financed by free cash flow mainly driven by the negative working capital of the model. Wayfair collects cash upfront from customers and pays suppliers on average in ~60 days. This meant the company could self finance the marketing plan to build Wayfair into a global furniture brand and has allowed the two co founders to retain ~14% of the shares outstanding each.

In 2016, Wayfair went one step further and began investing into physical assets to control the logistics process. Thus, CastleGate was born; a service that forward positions suppliers’ inventory in warehouses to improve customer delivery time and cost. Today, the company runs ~19m sq ft of warehouse space, cross docking facilities, sorting terminals, and last mile assets to facilitate global shipping of online furniture.

Just as Amazon increasingly moved to own more of the customer experience for general merchandise, Wayfair is doing the same for the home by combining their retail brand equity with freight forwarding capabilities focused on bulky items. Wayfair is building the home furnishings equivalent of Amazon’s FBA; let’s call it ‘Fulfilled by Wayfair’ (FBW).

There seem to be two important technologies powering FBW: CastleGate and Buyfair.

CastleGate is the foundation of ‘Fulfilment by Wayfair’; this is how the Former Fulfilment Engineering Head described the service:

“CastleGate is fulfilment by Wayfair; that’s the easiest way to describe it. It is a set of a great many fulfilment centers, many millions of square feet, in North America and Germany – and I think the UK as well – that is forward positioning, making product available, next day ideally, but certainly within three days, to the vast majority of consumers for Wayfair. It is a large number of very big warehouses, type one through type four. Type one would be stuff that you could put in a mailbox, moving all the way up to type four, which is something like a hot tub. They don’t call them warehouses; they call them fulfilment centers for a reason. It is a combination of a distribution center and a warehouse that are racked and highly automated for all those different classifications.” - Former Head of Global Fulfilment Engineering at Wayfair

CastleGate positions the suppliers’ inventory in Wayfair warehouses closest to the end customer. Suppliers pay ~35c per sq ft per month for storage plus other ancillary services which barely covers CastleGate's cost but, just like FBA sellers, CastleGate suppliers see 20% higher sales conversion relative to alternative drop shipping delivery methods. Because of the higher sales conversion, Wayfair achieves a lower product cost for CastleGate items which is accounted for as a contra-COGS item in the P&L.

CastleGate is a win-win-win proposition; suppliers turn inventory quicker at a lower cost, the customer gets a better service, and Wayfair drives higher sales and lower costs through fewer returns.

Since 2015, Wayfair’s total warehouse square footage has increased from 2m to 19m sq ft and the cost per order shipped has decreased ~10% to ~$30. Today, CastleGate processes only ~18% of large parcels and ~21% of small parcel volumes. As more suppliers adopt CastleGate’s services, it’s possible that the gross margin increases closer to 30%.

Wayfair has also launched Wayfair Delivery Network (WDN), large parcel middle and last-mile delivery, and International Supply Chain (ISC), a cross-docking and consolidation service for freight in Asia. However, it seems that Wayfair’s Buyfair proprietary technology is of even greater importance when trying to understand Wayfair.

“There is a system called Buyfair which is the secret sauce of Wayfair. It is one of the first things that really occurs. We do a demand forecast which is trying to decide where the people are who want to buy our big items? What are the big categories? Then it tries to come up with an allocation guide. I’ve decided that this black chair that I’m sitting on is going to sell 10,000 units in the next quarter and there’s going to be the highest demand in these different geographies, so it also tries to assign a demand plan. It then sends out a bunch of proposals to the suppliers. This black chair that I’m sitting in, probably has 50 suppliers that can provide it to us. There are a lot of items that only have one supplier, but there are also many that aren’t. They get a proposal and they look at it and say, I can fulfill that. They have the choice of whether or not they want to go CastleGate. “ - Former Head of Global Fulfilment Engineering at Wayfair

Buyfair is the engine that powers CastleGate; it helps route the huge number of SKU’s across all suppliers to CastleGate or dropship warehouses at the lowest cost possible. Wayfair is integrated with the production schedules of suppliers to route the orders as effectively as possible. This was cofounder Steve Conine during the October 2019 earnings:

“What makes the Buyfair technology both differentiated and challenging is that in order for it to do its job properly, we must optimize not just across our own network but also across our suppliers' networks. We seek to understand their manufacturing and logistics capabilities, including production quantities, time lines and locations and then figure out how to best complement them with ours.” - Steve Conine, Wayfair Q3 2019 earnings

This integration with suppliers can not only provide quicker deliveries, but an advantage in getting access to supply at lower prices. As Wayfair proves the conversion of Buyfair and CastleGate, the company can attract suppliers of all quality to sell products across their house of brands. This will extend the selection advantage whilst also being competitive on price and service.

Buyfair and CastleGate could also potentially form the foundation of a standalone freight forwarding service:

“Once you’ve already spent the money in investing and building out the capabilities, of course you leverage it and make it available. I try not to speak for Niraj and Steve but I think that their view was always that, ultimately, CastleGate becomes a third-party logistics company for anybody that wants to use it.” - Former Head of Global Fulfilment Engineering at Wayfair

Although other retailers may not be willing to use Wayfair’s forwarding services, it’s clear the company is focused on solving the problem of shipping large parcels. And we believe it’s hard to argue the co-founders are not the right people to find the solution.

Wayfair is making a bold bet that owning the full end-to-end logistics process will improve sales conversion, reduce damages, and lower fulfilment expenses. In hindsight, Amazon’s logistics infrastructure and service quality was pivotal in winning the battle over eBay for general merchandise ecommerce. Could FBW provide the structural advantage to Wayfair that FBA did to Amazon?

We believe there are some differences worth considering when comparing Wayfair with Amazon.

Firstly, the last mile for bulky items is far more difficult than small items. It's not clear how much scale Wayfair could benefit from in the last mile relative to competitors. For example, it still requires two people and a van to deliver a sofa. And there seem to be relative limits to efficiency when loading a van. This is different to general merchandise where Amazon can optimise the number of parcels per van and decrease the last mile cost per unit as volume increases. Wayfair's last mile also seems more difficult relative to internet auto retailers. Carvana can pick up 9 vehicles on one truck from one IRC and ship directly to customers across different markets. CarMax, on the other hand, offers free transportation of cars between branches within one market but pays a 3PL ~$1 per mile to transport vehicles to different markets. The relative cost savings of CVNA owning the last mile compared to CarMax seems more significant than for Wayfair in online furniture.  Wayfair's cost savings could come more from reducing the touch points in the supply chain; the more touches on a bulky item, the higher the return rate. CastleGate and WDN reduces the 'touches' and delivery times for bulky items by 67% and 75% respectively relative to drop shipping competitors. It's possible Wayfair that builds the most efficient drayage and middle-mile supply chain that reduces damages and delivery times and provide an advantage over competitors. However, it seems the last mile itself is similar in process and unit cost whether it’s WDN or a 3PL delivering the bulky items. And even if there were savings to be made, would it be enough to provide a structural advantage over competitors?

The picking and packing inside the warehouse is also very different. Amazon purchased Kiva and automated the majority of small parcel pick and pack to reduce the handling cost per unit. Carvana runs multiple assembly lines within an IRC to reduce inspection cost per car.  However, with current technology, it seems difficult for Wayfair to automate the handling of sofas, hot tubs, or any other bulky item.

The ‘skeletal structure’ of offline furniture retailing relative to general merchandise retailing could mean FBW is less important in improving Wayfair’s competitiveness than FBA for Amazon. The old general merchandise supply chain had suppliers ship to a central warehouse, and then deliver the products to stores to list as inventory on the shelf. Amazon took a large amount of cost out of the system by shipping products directly from fulfilment centres to customers.

Furniture logistics is different because retailers carry less inventory and run made-to-order supply chains: incumbent retailers can ship products directly from manufacturing to the customer via 3PL’s. This means traditional furniture retailers already miss out an expensive part of the supply chain that Amazon could take advantage of. This suggests that even if Wayfair does own the logistics, the cost savings could be less significant than Amazon vertically integrating in general merchandise or Carvana in autos.

It's hard to get a great comparison, but from 2002 to 2007, when Amazon’s revenue grew from ~$4bn to $14bn, similar to Wayfair’s growth between 2017-20, Amazon’s fulfilment expense as a percentage of revenue declined from over 10% to 8.4% (excluding 2% of revenue spent on free shipping). Wayfair’s fulfilment expense as percentage of sales has been consistent at around 14% even though revenue has tripled. The fulfilment cost per order has declined from $33 to $30 and there remains spare capacity in the 19m sq ft of warehouse space. This is a metric we will track closely.

Another important difference to consider when evaluating online furniture to general merchandise is customer behaviour and shopping experience. Relative to general merchandise, the home category is a more emotional and less frequent purchase that lends itself more to physical shopping. We simply enjoy shopping in stores for furniture and home decor far more than for batteries and nappies.

Although Wayfair can add more value in selection, merchandising and discovery, it’s arguably much harder to delight and retain customers. Many more things can go wrong when shipping a sofa relative to a pack of batteries. Damages and late deliveries on such big ticket items can lose potential Wayfair customers for life. The durability of products also lowers order frequency which increases the cost of order reactivation relative to general merchandise.

In hindsight, Nick Sleep was undeniably right for general merchandising internet retailing: the building blocks of Amazon is a far superior structure than offline retailers. For online furniture, the market isn’t too sure. In 2022, Wayfair is estimated to generate $15.5bn in revenue, revised down from pre-pandemic estimates. At the current valuation, assuming a 7% EBITDA margin in 2030, the company is priced to grow revenue ~10% per year until 2030. We believe the size of the problem and the high quality of the management team make this an interest company to follow. Maybe it's time to revisit Carvana too.